Question

FROM MACROECONOMICS, WILLIAMSON (5th Canadian edition) In the basic new Keynesian model, suppose that there is an increase in the future marginal product of capital.

a. Suppose that the central bank does nothing. What will be the effects on current inflation and output?

b. Suppose the economy has initially an inflation equal to the central bank's inflation target and an output gap of zero. When the shock occurs, what should the central bank do?

c. Explain your results in parts (a) and (b) with the aid of diagrams.

Thanks !

Answer 1

a. Increase in future marginal product of capital will lead to increase in investment spending today that will increase the aggregate demand. This would result in higher inflation and higher output.

b. To cope with higher inflation and inflationary output gap, central bank should decrease the money supply that leads to increase in interest rate. Higher interest rate increases the cost of investment. This decrease in investment decreases aggregate demand back to its initial level.

c. Increase in marginal product of capital shifts the AD curve rightward to AD'. Short run equilibrium reaches at e' where both price level and output are higher.

When central bank decreases money supply, AD' shifts back to AD and new equilibrium is back to initial equilibrium e.