We discussed how hard it is to keep AD stable or put it back where it belongs
Question:
To illustrate, let's see how things turn out if you, the central banker, take two years rather than one year to react to a negative velocity shock. You have better control over AD if you make small moves than if you make big moves, but big moves can get you back to the potential growth rate more quickly: As so often is the case in economics, you face a trade-off.
In this question, your ultimate goal is to get AD back to 5% per year; the potential growth rate is 3%, and expected inflation is always 2% per year.
Starting point (substitutes what you know into these equations and solve):
AD: 1% = Inflation + Real growth
SRAS: Inflation = Expected inflation + (Real growth €“ Potential growth rate)
a. Slow approach: Add 2% per year to AD for two years (through some mix of money growth and higher confidence). What will real growth equal each year?
b. Fast approach: Try to add 4% to AD in Year 1, but mistakenly add 7% instead (through some mix of excess bank lending and irrational exuberance). In the second year, try to correct by cutting back by 3%, but mistakenly cut back by 4% (through some mix of slower bank lending and investors' loss of confidence). What will real growth equal each year?
c. You can see how the "best approach" is a matter of taste, but which method would you expect a central banker to prefer if Congress has to decide whether to reappoint the central banker to a new four-year term in a few months?
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