Chapter 15, Problem 1QQ

To determine

The role of central bank in the dynamic model of aggregative demand and aggregative supply.

Answer to Problem 1QQ

Option ‘c’ is the correct answer.

Explanation of Solution

Option (c):

The dynamic model of aggregative demand and aggregative supply combines different economic relationships, a rule for monetary policy is one of them. Usually, the conventional simplification is that the central bank sets the money supply, thereby determining the equilibrium interest rate. However, in reality, many central banks set a target for the interest rate and allow the money supply to be adjusted to the level necessary to achieve that target. The target inflation rate is set by the central bank on the basis of economic conditions, and the central bank sets the nominal interest rate as a function of inflation and output. Hence, the central bank adjusts the nominal rate as conditions change.

Thus, option (c) is correct.

Option (a):

In reality, many central banks set a target for the interest rate and allow the money supply to adjust to the level necessary to achieve that target, where the target inflation rate is set by the central bank on the basis of economic conditions. Therefore, the central bank cannot ensure that the money supply grows at a constant rate.

Thus, option (a) is incorrect.

Option (b):

The real interest rate has a negative relationship between the demand for goods and services in an economy, while the natural rate of interest rate is the real interest rate at which, in the absence of any shock, the demand for goods and services equals the natural level of output. In the dynamic model of aggregative demand and aggregative supply, it is assumed that the natural rate of interest is constant, that is, the same in every period, but not the real interest rate.

Thus, option (b) is incorrect.

Option (d):

In the dynamic model of aggregate demand and aggregate supply, the central bank set a rule for monetary policy according to which the central bank sets the nominal interest rate as a function of inflation and output.

Thus, option (d) is incorrect.

Economics Concept Introduction

Dynamic model of aggregative demand and aggregative supply: The dynamic model of aggregate demand and aggregate supply describes about the short-run fluctuations in output and inflation and the effects of monetary and fiscal policies on those fluctuations.