Answer to Question #123460 in Macroeconomics for NATHAN

Question

HOW IS INFLATION, THE OUTPUT GAP AND MONETARY POLICY RELATED?

Answer 1

Inflation is an increase in the general price of goods and services in an economy over a given period of time. This occurs due to increase in production costs such as raw materials and wages.

Output gap refers to difference between the actual output in an economy and the maximum potential output of an economy .It is expressed as a percentage of gross domestic product. It is a comparison between the actual GDP (output) and potential GDP (maximum output).

Monetary policy is a policy adopted by a monetary authority of a country that often targets inflation to ensure price stability and general trust in the currency. Its purpose is to ensure stable circulation of money in an economy to prevent inflation.

Economists believe that very high rates of inflation are caused by excessive growth of money supply. The task of keeping the rates of inflation low and stable is usually given to monetary authorities. These are Central Banks that control monetary policy through the setting of interest rates, taxation and other policies

The output gap plays a central role in policy making whether it is positive or negative. A positive output gap indicates high demand for goods and services which may spur inflation in an economy. This implies an overheating economy and upward pressure on inflation. This may cause policy makers to cool an overheating economy by raising policy rates. A negative output gap indicates a lack of demand for goods and services in an economy and may lead to a sluggish economy because companies are operating below their maximum efficiency levels. This may prompt Central Banks to adopt a monetary policy designed to stimulate economic growth for example lowering interest rates. This is the long run prevents inflation from falling below the Central Banks inflation rate target.

Monetary policies have an important influence on inflation and some of these policies are adopted according to either there is positive or negative inflation. When there is high inflation policies such as taxation and raising interest rates are adopted to reduce demand and prevent inflation from rising above the inflation rate target. In case of low inflation policies adopted are such that they are meant to boost demand and restore the stability of a country's growth