Question

An open economy is currently in an inflationary gap. In attempt to reduce the inflationary pressure, the central bank decides to adjust the target for overnight rate to close the inflationary gap. What should the central bank do?. Also, describe how the monetary transmission mechanism works for the proposed change in monetary policy.

Answer 1

The Central Bank can increase interest rates in order to prevent people from borrowing excessive loans from the banks and thereby put a control on their spending levels. Increased interest rates will be represented by a leftward shift of the LM curve, which shows that at given interest rates, the demand for money has reduced. Higher interest rates also induce people to save more, and thus increased savings will in future lead to higher investment. Thus increased investment and reduced borrowings on unnecessary expenditure will lead to control on inflation.