Suppose that there is a wave of pessimism in the economy due to Covid-19 and, as a result, the economy is operating below its natural level of output with high unemployment and low inflation. So, the central bank decides to stimulate the economy. Assume a small open economy with perfect capital mobility and a flexible exchange rate system.
a) (i) Should the central bank increase or decrease the money supply if it wants to stimulate the economy? Explain.
(ii) List two monetary policy tools that the central bank uses to influence the money supply and explain how each tool should be applied to be consistent with your response in (i).
b) Which macroeconomic variables change immediately and in what direction?
c) Which macroeconomic variables change over the short run and in what direction?
d) What happens to employment and inflation? Does the rate of economic growth increase?