Question

For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a longrun equilibrium.

a. Consumers reduce autonomous consumption.

b. Financial frictions decrease.

c. Government spending increases.

d. Taxes increase.

e. The domestic currency appreciates.

Short answer

(a) A fall in autonomous spending reduces aggregate demand in the economy.

(b) A reduction in financial frictions will raise aggregate demand in the economy.

(c) Increased government expenditure will boost aggregate demand in the economy.

(d) Increases in taxes weaken aggregate demand in the economy.

(e) An increase in the value of the home currency will result in reduced exports and greater imports.

Step-by-step solution

Step 1. Introduction

The framework established by the central bank in order to accomplish economic growth and stabilise the country's economy is known as monetary policy.

Step 2. (a) Explanation

Because a fall in autonomous spending reduces aggregate demand in the economy, monetary officials must follow the route of easing monetary policy in order to stabilize economic activity.

Step 3. (b) Explanation

A reduction in financial frictions will raise aggregate demand in the economy, and monetary policymakers should tighten the monetary policy to stabilize economic activity.

Step 4. (c) Explanation

Increased government expenditure will boost aggregate demand in the economy, and monetary policymakers should tighten their monetary policy to stabilize economic activity.

Step 5. (d) Explanation

Increases in taxes weaken aggregate demand in the economy, and monetary officials must loosen monetary policy to stabilize economic activity.

Step 6. (e) Explanation

An increase in the value of the home currency will result in reduced exports and greater imports, lowering net exports and aggregate demand, and monetary officials will need to loosen monetary policy to stabilize the economy.