Why is it important for a central bank to prevent deflation? 2. If an economy we

Question

Why is it important for a central bank to prevent deflation? 2. If an economy were suffering from a fall in demand that caused deflation and if the central bank refused to provide the stimulus needed to raise aggregate demand, what other actions could the government take to bring the economy out of its slump? 3. Suppose that an economy is suffering from a rapid rate of deflation, perhaps at 20% per year. By cutting interest rates to zero, the central bank can only reduce the real interest rate to 20%, still a very high level. Can you think of some extreme action that the central bank could undertake that would drastically increase the purchases that consumers want to make and would, therefore, start to make prices increase? To complete this assignment, check the following box: I have read the discussion questions on this page and am finished with this analysis.

Explanation / Answer

Q2. If an economy is suffering from fall in demand which is causing deflation then it needs either the administration of expansionary monetary policy or expansionary fiscal policy or a combination of both to stimulate or raise the aggregate demand and arrest the decline in price level so as to pull the economy out of deflationary and recessionary environment.

It has been provided that the central bank has refused to provide the stimulus needed to raise the aggregate demand. In other words, central bank has refused to administer the expansionary monetary policy.

In such scenario, government can undertake expansionary fiscal policy (it is the government that administers the fiscal policy).

Expansionary fiscal policy involves either increase in government spending or reduction in taxes or a combination of both.

This action of government will result in increase in government spending (if government purchases are increased) or consumption spending (if taxes are cut).

Both of these are component of aggregate demand and increase in these will bring an increase in aggregate demand as well.

This increase in aggregate demand will arrest the decline in price level and will pull the economy out of deflationary environment.

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