Annual Inflation Year Inflation Rate 2000 2.1% 2001 2.7% 2002 1.3% 2003 2.9% 2004 2.6% 2005 3.2% 2006 2.4% 2007 4.2% 2008 4.1% 2009 0.1% 2010 3.7% 2011 5.1% Unemployment Rate of UK’s economy is exhibiting a trend of rising with the inflation rate of the economy. This is considered one of the most challenging macroeconomic situations in macroeconomic text books. This is because a high inflation is generally associated with lower levels of unemployment since all factors of productions are considered to be highly utilized. Rising unemployment with inflation indicates major issues with the economy which need to be resolved (Henderson, 2003). Unemployment Rate Year Rate 2001 5.1% 2002 5.2% 2003 5.0% 2004 4.8% 2005 4.8% 2006 5.4% 2007 5.4% 2008 5.6% 2009 7.5% 2010 7.9% Deflationary Gaps and Appropriate Policy Responses Deflationary gap in an economy is the difference between the potential performance of the economy – in terms of total value of goods and services produced - and its actual performance.
This gap shows the level of improvement which can be attained within an economy through appropriate policy response. Price Level SRAS Deflationary Gap AD Real GDP Appropriate policy responses to deal with deflationary gaps comprises of increasing discretionary government expenditure for the economy (Laxton, NDiaye and Pesenti, 2006). Also, reducing taxes on businesses and subsidization of certain industries can serve to reduce deflationary gaps and increase Gross Domestic Product of the economy (Grossman, 2005).
Question 2 – Explain the objectives of monetary policy and the mechanism through which Monetary Policy operates to control inflation. Monetary Policy Monetary policy refers to the use of corrective actions by the monetary authority of the country – usually the central bank – to fulfill its objective of macroeconomic stability by using money supply. Monetary policy strives to achieve the various objectives of economic policy, which include economic growth, achieving full employment and managing external balance. Monetary policy is known as collective use of tools by central bank to achieve predefined goals. Monetary policy differs from fiscal policy (Baurnol, 2011). These two policies interact and together form the policy mix. The Objectives Of Monetary Policy According to modern economic theory, the objectives of monetary policy is to maximize economic welfare of households.
This is generally attributed to two main objectives of monetary policy - price stabilization and stimulation of economic activity. These two objectives are closely linked.
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