Answer to Question #115024 in Macroeconomics for Sura Alnaimy

Question

Suppose central bank applies inflation targeting. What would be the central
bank’s interest rate response if there is an increase in output (Y)? Graph the Aggregate demand (AD) curve and explain the shape of the AD curve.

Answer 1

Inflation targeting refers to a monetary policy where the central banks sets a specific inflation rate. The central bank uses the inflation targeting to make people believe that prices will continue rising .Due to this most people will buy more goods when prices are low.

It prepares people of future price rice in order to create a healthy economy. This creates more demand in the economy.

In order to keep the economy running smoothly the Central bank will adjust to the interest rates that is the supply of money.

In the long run, output fixed and is usually measured by Gross Domestic Product therefore, changes in the money supply only cause prices to change. While in the short run since prices and wages do not adjust immediately, changes in the money supply can affect the actual production of goods and services.

Decrease in money supply will lead to decrease in consumer spending it will make the aggregate demand curve to shift to the left. While increase in money supply will lead to the aggregate demand curve shifting to the right.

It is illustrated by the following graph .