Question

Suppose the central bank is following a constant-money-growth-rate rule and the economy is hit with a severe economic downturn. Use an aggregate supply and demand graph to show the possible effects on the economy. How does this situation reflect on the credibility of the central bank if it maintains the money growth rule? How does it reflect on the central bank's credibility if it abandons the money growth rule to respond to the downturn?

Short answer

The graph depicts the various consequences on the economy in a given situation, as well as how the situation reflects the government's credibility when it maintains the money growth rule and when it responds to the downturn.

Step-by-step solution

Concept of credibility 

The term "credibility" refers to one's belief in another. It is the level of confidence that one individual or institution has in the other. When using debt or credit to finance a project, credibility is essential.

Step 2. Explanation

The following graph depicts the potential economic repercussions in a specific situation:

The likely consequence on the economy in the above situation, as shown in the graph above, would be an increase in inflation and a fall in output due to a decrease in supply due to the downturn and an increase in demand.

As long as the government maintains the money growth rule, the government's and policymakers' credibility may be harmed because people's expectations of low inflation from the government will be lowered. However, if the government responds to the downturn, people's expectations of low inflation from the government will rise, boosting the government's credibility. As a result, when the government maintains its money growth strategy, credibility suffers, whereas when it responds to the downturn, it gains.