The graph on the right shows an IS-LM graph for an economy Point C on the graph

Question

The graph on the right shows an IS-LM graph for an economy Point C on the graph represents the economy at potential output, Yn with the natural rate of interest, rn Assume that expected inflation is equal to last years inflation If the economy started at point C and moved to point A2. the best way to describe the economy s at ia nou jecesinary an and there is downward pressure on inflation. In order to move the economy from point A2 to point B2. what policy prescription would the central bank need to follow? LM 82 A2 O A. O B. The central bank must decrease the policy rate The central bank must increase the policy rate IS C. It must adjust the nominal rate in order to keep the real policy rate constant When the economy reaches point B2. inflation will Output Y stabilized and constant If the central bank is the level of inflation will be lower than originally at point C successful in returning the economy to point C it was when the economy was

Explanation / Answer

When actual output (at point A2) is greater than the potential output, then there is a situation of inflationary in economy which lead to a upward pressure on inflation.

So, the best way to describe the economy is that it is now inflationary and there is upward pressure on inflation.

Increase the interest rate is one of the solution from monetary policy tool to deal with the inflationary gap.

So, central bank should increase the policy rate.

Correct answer is an option (b).

Iflation rate will be stabling and constant at point C. After reaching to point B2, the infaltion rate will continue to fall till it reaches to point C.

After returning to point C, the inflation level will be same it was before.

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