Question

Suppose a natural disaster destroys some of the nation’s capital stock, K1. If the central bank’s goal is to stabilize the price level, what should it do in response to the disaster? Compare and contrast the policy response in the real business cycle model, Keynesian coordination failure model, and New Monetarist model.

Answer 1

Solution 1st part
A reduction in the capital stock due to a natural disaster will cause the supply of capital curve to shift leftwards hence driving up the cost of capital. This will in turn caused the marginal productivity of capital to rise and hence drive up the interest rate and cause instability. In such a situation, the central bank will need to use monetary instruments to ensure that the interest rate comes down. It will seek to infuse money supply into the economy and hence cause the interest rate to fall and stabilize the price level.