Question

In this question, you should analyze the effect of price control to keep low inflation rate in the AD-AS framework. For simplicity, assume that the economy is in a full employment equilibrium initially. The government controls prices in stores to avoid inflation. Namely, they do not allow the changes in prices in stores. What would happen to output and the price level when the central bank increases money supply? Explain using the AD-AS diagram.

What would happen to output and the price level once the government eliminates price control in the question above? Explain using the AD-AS diagram.

How is your answer to question (1) related with question (2)? Is there any similarity?

In practice, is there any problem/issue for this price control? Explain your thoughts. Hint: Again, you can think about how your answer to question (1) is related with question (2) and (3). Instead of the similarity, is there any difference?

Answer 1

When central bank increased money supply in market using an expansionary monetary policy the market will have enough room for growth as Consumption will boost and individual will have higher savings. This will cause aggregate demand to rise and inflation to rise because prices also rise for services and non core sector. Since price control is seen the core inflation doesnt rise and this offsets the overall inflation. Hence real GDP or output also grows marginally.

The services or noncore Inflation will rise as there is no price control however the core inflation will remain same as store level core prices ate controlled. Now if Government eliminated price control the overall demand and consumption growth rises substantially and hence GDP also grows marginally albeit grows.