Problem
Beginning in 2022 central banks around the world began to respond to increasing inflation rates by increasing their policy interest rates. This problem explores the reasons for these policy decisions and the expected results.
i. Using an AD-AS diagram, explain two potential causes of inflation above target if we assume target inflation is associated with long-run macroeconomic equilibrium.
ii. Explain the effects of the decision on interest rates and how the central banks must respond to support this policy decision. [Hint: Use a diagram for the money market, make sure to discuss the adjustment to the new equilibrium in the money market.
iii. What effect will the policy change have on investment, on aggregate expenditure? Include diagrams in your answer.
iv. What additional effect will there be on aggregate expenditure if the economy was an open one?