Question

Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country's central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

Short answer

The lower the level of credibility in country B, the lower the level of supply, the higher the rate of inflation and the lower the level of output in that country, whereas the higher the level of credibility in country A, the higher the supply, the lower the rate of inflation and the higher the level of output in that country.

Step-by-step solution

Step 1. 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

Credibility affects the aggregate supply curve by changing the public's expectations in an economy. When the public has less faith in the central bank, it means that people have less faith in the bank, and inflation will be reduced and stabilize. As a result, people will begin to reduce supply in anticipation of an increase in inflation, causing the aggregate supply curve to shift upward. Increased inflation and lower output would result from a reduction in aggregate supply. More credibility, on the other hand, might lower inflation by increasing public expectations of lower inflation, resulting in an increase in the aggregate supply curve.

The aggregate supply and demand curve for country A looks like this:

Step 3. Explanation

The graph of the aggregate supply and demand curve for country B is as follows:

The impact of credibility on the aggregate supply and demand curves of nation A and country B may be observed in the graphs above. The lower the level of credibility in country B, the lower the level of supply, the higher the rate of inflation and the lower the level of output in that country, whereas the higher the level of credibility in country A, the higher the supply, the lower the rate of inflation and the higher the level of output in that country.

As a result, high credibility reduces inflation while increasing output and poor credibility raises inflation while decreasing output.