Economy & Effects of Inflation Questions Essay

1) A central bank is facing the following problem. There are signs that inflation is picking up in the economy. Some analysts suggest that this is a temporary phenomenon, and that in a few quarters, inflation will again be consistent with the inflation target set by the central bank.

Other analysts point instead to the possibility that the current pick-up in inflation will not be temporary and that, absence any central bank action, the future inflation rate will exceed the inflation target for a significant amount of time.

As the adviser to the Governor, you will have to brief her on the options she needs to consider. In particular, she needs to be briefed on what would be the consequences of: (i) relying on analysts who think the current inflation is temporary if this turns out to be wrong, versus (ii) relying on the analysts who think the current inflation is more permanent if it turns out that this is not the case.

2)Your Governor has received policy advice from the Heads of two Departments in the bank, the External Department and the Monetary Policy Department. As his trusted Counselor, the Governor has asked you to explain the macroeconomic logic behind each of the proposals he has received. The Governor would also like you to explain whether, in the context of your economy, one of them is more appropriate than the other. To answer this last part of the question, you may need to make assumptions about the structure of Saudi economy. You will not be assessed on which assumptions you make, but rather on whether your advice is consistent with your choice of assumptions.

Advice 1, External Department.

“We need to pursue an expansionary monetary policy to engineer a depreciation of our currency so that we gain international competitiveness for our export industry, improve our current account balance, and increase employment.”

Advice 2. Monetary Policy Department

“A depreciation of our currency will only lead to wage and price inflation, and will have no lasting impact on competitiveness, the current account balance, and employment. We should instead focus on achieving our inflation target.”

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3)Your Governor is contemplating lowering the policy rate to stimulate the economy since the current and forecasted inflation rate is below target, and since output is currently below potential. But the Governor is uncertain about whether lowering the policy rate will actually be transmitted to the broader economy and to inflation in particular, since the policy rate is a very short-term (overnight) interest rate that directly affects principally activity in the interbank market.

The Governor has asked you to brief her on the nature of the transmission mechanisms of monetary policy, in particular on the interest-rate channel, the credit channel, and the exchange rate channel. In particular, she would like to know what conditions in the economy might make the transmission mechanism less effective than hoped for.