Suppose that production is on the natural level. Now there is an increase in the price level because of an increase in the value added tax.

(a) What happens to production in the short run if the central bank keeps the money supply constant? Explain, and support your answer with an appropriate graph.

(b) What do you think that the central bank should do in this situation? Explain.

1. (a)Students should draw an appropriately labelled IS-LM graph, noting that if the money supply is held constant, the real money supply will decrease and the LM curve will shift inwards. The interest rate will increase and production will fall.
2. (b)By increasing the money supply, the central bank can keep the interest rate constant and stabilize production but at the price of a temporary increase in inflation. How the central bank will react depends on how it weights the stability of production versus the stability of prices (this will be covered further in the next chapter).