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Why the central bank should change the interest rate in response to an increase in consumer spending brought on by increased optimism in the future of the economy?
The central bank may lower or raises the interest rate depending with the prevailing economic conditions. If the central banks increases interest rates, this will in turn affect the commercial banks making the commercial banks to increase their prime or lending rates. The increased interest rates will directly or indirectly affects mortgage rates, business loans, consumer loans and any other financial related issues like car loans. When there is increase in consumer spending the central banks will raised the interest rates, this is because high-interest rates are intended to slow down the economy by making borrowing harder for the consumers and any other borrowers. In doing this the central bank will not spur the economy but will be mopping out the excess currency flow into the economy.
The IS-MP curve below illustrates the point.
The IS-MP curve illustrates how the central bank sets the interest rates in respond to the level of income Y. During boom in the economy, the central banks leans against the wind hence raising interest rates(r) and thus discourages further spending by the consumers or rather limits the value of goods to be consumed. The MP curve that is to the horizontal, will go up and the income of the consumers will be effected by the slope of the IS curve.
The Philips Curve
Since higher spending by the consumers will leads to inflation, Philips curve explains how the central bank can increase interest rates to reduce consumers spending thus reducing inflation in the short-run. In the labor market, when unemployment reduces due to abundant labor supplies, the firms will be forced to cut the wages of the employees and this will reduce pressure on the wages and prices will eventually fall.
- The economy starts off in recession. A fiscal stimulus through increase governments is implemented, but it is not so large that it brings the economy all the way back to full employment (in other words back to potential output level)
- a) Initially assume no monetary policy response to this scenario. Show the effects of this fiscal stimulus on the economy in the short run using IS-MP and Philips curve diagram. Explain briefly.
THE IS-MP CURVE
In the short-run when government implement a stimulus to the economy under recession, the IS curve would shift to the right thereby increasing the consumers income. From the graph the interest rates are constant meaning in the short-run the level of the output will increase, but will not reach the potential level.
The Philips curve
During the recession, the economy perform below the required level and the output level is less than the maximum output level. During this period the level of unemployment is high and can be attained at U1 and the wage inflation is relatively lower and is attained at W1. The government stimulus will spark economic growth and this will leads to higher income hence putting the wage inflation slightly below W2 and unemployment slightly above U2.
b). If the central bank decide they want to assist the economy in moving back towards full employment what should they do and why? Show this graphically as well.
The central bank should lower the interest rates charge on commercial banks. By lowering the interest rates, many commercial banks will borrow more money from the central banks at relatively lower interest rates. Lower interest rates will subsequently enable the commercial banks to charge lower interest rates to the consumers and his will spur the level of economic activity in the economy. Further lower interest rates will make many financial institutions to lend money to the companies and other business sectors and this in return will create more jobs resulting into a reduction in the unemployment level. The maximum output level is attained at the point where W2 meets the U2 and the economy is said to have moved back towards full employment as illustrated by the Philips curve bellow.
Are there any other concerns the central bank should have when enacting their policy to bring the economy towards potential output level? Explain briefly
Yes
The central banks should other factors which affect the economy other than the interest rates and the monetary policies. The monetary or fiscal policy when not properly followed may leads to economic retardation. For, example the central banks need to control the rate of inflation in the country, however, some measure should be put in place not to reduce it to zero levels. This is because lower inflation rates motivate the producers and this leads to job creation. The economists argue that inflation in an economy may motivated some individuals to work harder especially the producers and this leads to job creation and hence reducing the rate of unemployment rates.
The interest rates should be control at a reasonable level to facilitate economic growth. When there is much money in the economy, the excess should be mopped out to prevent the economy from experiencing higher inflation rates. The central banks should also have in mind the natural factors like fire, floods; droughts may course uncertainty in the economy. The natural factors like floods and droughts may lead to loss of business and course uncertainty in the economy and may subsequently leads to recession in an economy.
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