Question

Suppose an economy has witnessed an 8 percent rate of growth in its money supply and prices over the last few years. How do you think the public will respond to an announced plan to increase the money supply by 4 percent over the next year if: a. The central bank has a reputation for always meeting its announced policy goals. b. The central bank rarely does what it says it will do.

Short answer

Answer: The public's response would vary depending on the credibility of the central bank. In scenario (a), where the central bank has a good reputation, the public is more likely to adjust their expectations and behaviors according to the announced plan. In scenario (b), with a less credible central bank, the public might be more cautious and rely on alternative sources of information to form their expectations.

Step-by-step solution

Scenario A: The central bank has a reputation for always meeting its announced policy goals.

If the central bank has a good reputation for always meeting its policy goals, the public is more likely to believe that the central bank will actually follow through with its plan to increase the money supply by 4 percent over the next year. In this case, people's expectation of inflation will adjust accordingly, and their inflation expectations will lower to the central bank's announced plan of 4 percent (from the current 8 percent rate). As a result, the public might do the following: 1. Reduce cash holdings and invest in interest-bearing assets or durable goods in anticipation of lower inflation in the near future. 2. Adjust wages, salaries, and prices to accommodate the expected decrease in the overall inflation rate. 3. Rely on the central bank's public announcements about future policy actions as a reliable source of information.

Scenario B: The central bank rarely does what it says it will do.

On the other hand, if the central bank has a history of not following through with its announced policy goals (i.e., a lack of credibility), the public may have a harder time trusting the central bank's announcement about increasing the money supply by 4 percent over the next year. In this case, their inflation expectations might remain around the present 8 percent rate or only partially adjust to the central bank's plans (somewhere between 4 percent and 8 percent). In this scenario, the public might take these actions: 1. Remain cautious when it comes to making decisions based on the central bank's announcements about future policy plans. 2. Hold on to their cash holdings and avoid making significant investments or changes in wage and price setting behavior until they see actual evidence of the central bank implementing its plan and decreasing the inflation rate. 3. Seek alternative sources of information about the economy and future inflation rates. In conclusion, the public's response to the announced plan to increase the money supply by 4 percent will largely depend on the credibility of the central bank. If the central bank is considered credible, people are more likely to adjust their expectations and behaviors accordingly. If the central bank's credibility is low, people might be more cautious and rely on alternative sources of information to form their expectations.