Question 1 (10 marks)

You are a ministerial advisor within the Ministry of Finance in your country. The Finance Minister has a few minutes to have a quick chat with you before going into an unscripted television interview on the matter of monetary policy. She has a query which she puts to you, and she seeks your response.

The background to her query is explained here. The economy had previously been at an equilibrium level of output and price acceptable to the government and the independent central bank (indeed the output level was at long-run output [Y*]), such that the price level = P₀ and output level (Y₀) = Y*. EP refers to expected price, which in period 0 is equal to price P₀.

Suddenly there is a huge spike in oil prices that induce a sizeable negative shock to aggregate supply moving it from AS₀(EP₀) to AS₀'(EP₀), creating a negative output gap (aggregate demand AD₀ remains unchanged) as output falls to Y₁ and inflation as prices rise to P₁. Price level P₁ is within the comfort zone of the central bank as the inflation level is still within its target band, but it is at the very upper bound of the target. This is graphically depicted below:

The government has no fiscal policy space to react to this negative shock as its budgetary situation is precarious and so it has decided not to act, hoping that the independent central bank with use expansionary monetary policy instead to shift the aggregate demand curve upwards.

1. The minister wishes to tell the interviewer that she is confident that the actions of the central bank will lead to an improvement in output (Y) in the short-term as it will lower interest rates (i.e. increase the money supply in the economy). You need to tell the minister whether you agree or disagree with her assertion, and explain why this is so. You should explain your response both in words and graphically as to why you agree or disagree with the minister.
2. The minister also wishes to state that, in general (so not necessarily based on the situation above), that the price level has no influence on output in the short-term. Using your knowledge of rational expectations, inform the minister whether or not you agree with her and explain why this is so.