Question

(a) Define the aggregate demand schedule. (b) How does a fiscal expansion affect the schedule under a flexible inflation target? (c) How would the central bank have to change monetary policy to hit its given inflation target in the long run?

Short answer

Fiscal expansion increases demand and inflation, requiring a monetary policy adjustment like raising interest rates to maintain the inflation target long term.

Step-by-step solution

Understanding Aggregate Demand

The aggregate demand schedule represents the total quantity of goods and services demanded across all levels of an economy at various price levels, holding other factors constant. It is typically downward sloping, as higher price levels tend to reduce the real purchasing power of money, leading to lower quantity demanded.

Impact of Fiscal Expansion

A fiscal expansion, such as increased government spending or tax cuts, shifts the aggregate demand schedule to the right. This is due to the rise in overall demand resulting from increased consumer spending and investment stimulated by government policies.

Effect under Flexible Inflation Target

Under a flexible inflation target, the central bank allows for some temporary fluctuations in inflation to accommodate changes in economic conditions. A fiscal expansion leading to higher aggregate demand may initially increase inflationary pressures, but the central bank would likely tolerate this short-term variation to support growth.

Monetary Policy Adjustment

To ensure inflation returns to its target in the long run after a fiscal expansion, the central bank may need to adjust monetary policy by increasing interest rates. Higher rates will eventually dampen demand, realigning actual inflation with the target level without derailing economic growth.

Key concepts

Fiscal Expansion

Fiscal expansion refers to the increase in government spending and/or reduction in taxes aimed at boosting economic activity. It is a deliberate policy by the government to enhance the overall demand in the economy.

• Increased government spending injects more money into the economy, creating jobs and increasing consumer income.
• Tax cuts boost disposable income, encouraging consumer spending and business investments.

These measures shift the aggregate demand curve to the right. A higher demand can lead to economic growth, but it might also introduce inflationary pressures if output does not keep up with demand. Fiscal expansion is particularly effective during periods of economic recession, where private demand is weak, and the economy operates below its potential.

Inflation Target

An inflation target is a specific benchmark inflation rate set by the central bank to guide its monetary policy. It ensures that inflation remains within a predictable and stable range.

• Central banks commonly target a low and stable rate, such as 2%, to foster long-term economic growth and stability.
• This target helps anchor inflation expectations, reducing uncertainty in economic decision-making.

Flexible inflation targeting allows for some fluctuation in inflation rates in response to short-term economic changes. For instance, during a fiscal expansion, temporary higher inflation might be tolerated to support jobs and growth, provided that inflation does not deviate significantly from the target over the long term.

Monetary Policy

Monetary policy includes the actions undertaken by a central bank to manage money supply and interest rates. It is the tool used to achieve macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. To respond to fiscal expansion and maintain an inflation target, adjustments in monetary policy become crucial:

• To curb inflation, central banks might increase interest rates, making borrowing more expensive and slowing down spending and investment.
• Alternatively, if inflation falls below the target, a central bank might lower interest rates to incentivize borrowing and spending.

Careful calibration ensures that the economy grows at a sustainable pace while keeping inflation within target limits.

Central Bank

A central bank is a national authority responsible for overseeing the monetary system for a nation (or group of nations), controlling the money supply, and setting interest rates. Central banks have the crucial role of maintaining inflation targets and ensuring financial stability. Some key functions of a central bank include:

• Managing monetary policy to influence economic activity.
• Setting benchmark interest rates that affect the economy's lending and borrowing rates.
• Acting as a lender of last resort to stabilize the financial system in times of crisis.

In the context of fiscal expansion, a central bank may adjust interest rates to balance higher aggregate demand and its inflation target, ensuring economic growth does not lead to runaway inflation.