2004 to 2010 Inflation rate fluctuates from year to year. It does not increase or decrease at the same rate. It started to grow at 3.72% in 2004 and rose to 8.17% before reaching the peak of 12.04%. This therefore means that the inflation rate increases at a decreasing rate depending on the aggregate demand of the country. 2 Trend in Money Supply
2004 to 2010 The trend of supply increases with the increase in the level of output. It increases with the increasing rate from 2004 to 2010. 2 TOTAL Marks b).Identify the relationship between the movement in the money supply and the inflation rate from2004 to 2010(e.g. positive, negative or no relationship). Use the data to provide a justification for your choice. (6 marks)
Relationship between Money and Inflation Positive Relationship
The relationship between money supply and inflation is in real output. A change in real output affect both inflation and money supply (Klein, 2004). This is because when there is an increase in money supply at a constant growth rate in real output, there will be an increase in aggregate demand which caused inflation and the reverse is true. From the above graphs, there is an equal growth in both money supply and real output level thus there is no change in price level (Taylor, 2008). Because of this there is a positive relationship between inflation and money supply. 4 TOTAL 6 Marks c).The central bank has just recently announced that due to the high price level, which has led to rising inflation, it would mop up excess money from circulation. Based on the relationship between money supply and inflation observed from 2004 to 2010, do you think there is any justification for the central bank to mop up money from circulation? Use references to support your response. (6 marks)
Should they mop up? (Yes/No) I think they should mop up money in circulation 1 Justification Moping money by the central bank reduces excess money in circulation thus reducing aggregate demand which reduces prices of different commodities. Through this method inflation rate will reduce as output level increases. 5 TOTAL Marks d).Explain two economic consequences for an individual and two economic consequences for an economy of an increase in its price level.(12 marks)
Individual Consequence # 1 Consumption level reduces 1 Explanation The income of an individual will be able to acquire fewer products. 2 Individual Consequence # 2 A reduction in the purchasing power of money 1 Explanation An individual will use a lot of money to buy fewer goods 2 Economy Consequence # 1 Production level reduces 1 Explanation Because the cost of factors of production is high hence increasing the cost of production. 2 Economy Consequence # 1 Excess production 1 Explanation When price increase, companies will produce excess products to maximize profit thus compromising product quality. 2 TOTAL Marks e).Carefully discuss the specific tools/instruments the central bank could utilize to achieve its objective of curbing inflation.(12 marks)
Tool #1 Price Control 1 Explanation Tool #1 The Government may either use price floors and price ceiling in order to control the price of different commodities (Klein, 2004). When there is inflation, the Government releases its products in the market to increase supply thus reducing demand forcing prices to reduce. In the contrary when prices are very low the Government buys products from producers to increase prices. 3 Tool #2 Monetary policy 1 Explanation Tool #2 This tool helps the Government to control inflation by increasing interest rates of borrowing money from the commercial bank (Corsetti, 2011). This reduces money supply which ensure there is excess money in circulation 3 Tool #3 Fiscal policy 1 Explanation Tool #3 The Government control inflation by using fiscal policy. It allows the government to rather reduce public expenditure or reducing private spending. Private spending is reduced by imposing more tax on most commodities for private businesses (Corsetti, 2005). When there is an increase in private spending, the Government reduces its expenditures which reduce the amount of money in circulation thus reducing inflation. 3 TOTAL 12 Marks
Corsetti, G., Pesenti, P. (2005). International dimensions of optimal monetary policy. Journal of Monetary Economics, 52(2), pp. 281305.
Corsetti, G., Dedola, L., Leduc, S. (2011). Optimal Monetary Policy in Open Economies. In B.M. Friedman and M. Woodford (Eds.). Handbook of Monetary Economics, vol. III. Amsterdam: Elsevier.
Klein, Lawrence (2004), 'The contribution of Jan Tinbergen to economic science', De Economist 152 (2), pp. 155-157.
Taylor, Timothy (2008). Principles of Economics. Freeload Press. ISBN 1-930789-05-X.
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