Answer to Question #163144 in Macroeconomics for Kinga

Question

(a) Suppose the economy is at potential output and the BP curve is shifted to the left, for example, by migrants into the country sending money earned in the country back home to their families at a higher rate. Suppose policy makers wish to maintain employment at potential output and avoid inflation but are willing to tolerate changes in the interest rate. What policy prescription would you recommend? Assume: (i) a fixed exchange rate and (ii) a flexible exchange rate. Assume a BP curve is steeper than the LM curve in both cases.                                                                                                                                                                           

(b) How would your answer to question 5 (a) differ if the policy makers, in addition to minimizing inflation and maintaining employment at potential output, they also want to keep the interest rate at its original level? Explain.

Answer 1

(a) I would recommend the increase in interest rate either at a fixed exchange rate or at a flexible exchange rate regimes.

(b) If in addition to minimizing inflation and maintaining employment at potential output, they also want to keep the interest rate at its original level, then the decrease in money supply may be done through open market operations.