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Question

1. Consider the following statement: ‘When it comes to dealing with a recession, the central bank’s strategy should always be not just to return the economy to the trend, but also to increase output even further to let inflation increase to its medium run rate.’
2. Use the IS-LM-PC model to provide explicit and well-argued reasons why you agree or disagree with this statement. If you disagree, under which circumstances could the statement be true? Support your reasoning using the example of an increase in competition between firms in the IS-LM-PC model.

Answer 1

Agree:

1. During a recession, the output gap is usually negative, and the IS (Investment Savings) curve shows the relationship between output and the interest rate. An increase in the money supply (shifting the LM curve) can lead to lower interest rates and increased investment, which helps narrow the output gap.
2. In the short run, the Phillips Curve (PC) shows an inverse relationship between inflation and unemployment. Allowing output to increase above potential can lead to lower unemployment, even if accompanied by a temporary increase in inflation.

Disagree with the statement:

1. In the long run, the trade-off between inflation and unemployment disappears along the expectations-increasing Phillips curve. If individuals and firms expect higher inflation, this can lead to wage and price regulatory behavior that hinders short-term profits, leading only to higher inflation without sustained output growth.
2. Central banks often have inflation targets to maintain price stability. Allowing inflation to rise in the medium term could conflict with the central bank's commitment to its inflation target, undermining credibility and potentially undermining inflation expectations.
3. Circumstances in which the statement may be true:
4. When increased competition leads to productivity improvements and a positive supply shock, it can improve the economy and aggregate supply. In this case, increased production may not lead to a significant increase in inflation, which is consistent with the statement and proposal.
5. If the central bank can effectively manage expectations and communicate that a temporary rise in inflation is part of a well-thought-out economic recovery, it can mitigate the risk of unanchored inflation expectations. In sum, the appropriateness of the central bank and strategy depends on factors such as the nature of the recession, the effects on aggregate supply and the ability of the central bank to manage expectations. Increased competition, which has a positive effect on total supply, may be a point where the strategy may be effective.