Question

6. You are the new leader of Egypt’s central bank. Egypt has been experiencing high inflation, and your task is to reduce that inflation rate.

a. What policy actions can your central bank take to reduce inflation?

b. In a well-labeled graph, show how your policy actions affect the trade-off between inflation and unemployment in the short and long run.

c. Explain how inflation and unemployment change over time as a result of your policy actions

Answer 1

Inflation occurs when an economy grows due to increased spending. This leads to price rises and the same amount of money is worth less than it was before. There are many steps that the government can undertake to control inflation - some have damaging effects. For example, controlling inflation through wage controls can lead to unemployment.

The central bank can take the following steps to reduce inflation:
1. Contractionary monetary policy: the goal here is to reduce money supply in the economy by decreasing bond prices and increase interest rates, hence reducing spending. The central bank can increase interest rates in this case, resulting in a country-wide increase in interest rates across banks.
2. Reserve requirements: the central bank can increase reserve requirements on the amount of money banks are legally required to keep on hand. The more money banks keep, the less they will lend and less spending will occur.
3. Reducing money supply: the central bank can call debts that are owed to the government or increase interest paid on bonds - a large amount of money thus goes out of circulation.

The relation between inflation and unemployment can be seen using Phillips curve. High inflation is association with low unemployment.



The kind of inflation Egypt is dealing with occurs due to increased spending. As a result of the central bank's policy actions, there will be a reduction in the money in circulation in the country. Increased interest rates will mean that less people will borrow from banks. There will be an overall decrease in spending. Demand drops and more workers will find themselves without a job. (the relationship is not this simple and depends on the kind of inflation we are dealing with. In this case, since inflation is due to spending, we can make this generalised statement)

"The inverse correlation between inflation and unemployment depicted in the Phillips Curve works well in the short run, especially when inflation is fairly constant. It does not hold up over the long-term since the economy reverts to the natural rate of unemployment as it adjusts to any rate of inflation."