Homework AS

Homework AS economics

The article (http://www.economicshelp.org/2009/10/inflation-and-optimal-interest-rates.html) is looking for the optimal interest rates to keep the inflation between 1 and 3% and also to ensure economic growth.

CPI fell to 1,1% last month, we should note this is annualised. This means that the CPI fell to around 0,1% in the month stated.

I think the article correctly states that an inflation rate of above those boundaries (1 to 3 per cent) are less dangerous and risky for the economy than inflation rates below those boundaries. Especially if the citizens have large debts.

The article states the UK has the biggest output gap in entire Europe. So what is the optimal interest level and what are possibilities to solve this problem?

The inflation is low – 1,1% - and there is a huge large negative output gap. Probably the best to do is to increase AD, but how?

AD= C+I+G+(X-M)

This shows there are several options for increasing taxes:
- Stimulating C- C=c(Y-T) +Co – This might therefore be done by a cut in taxes. (T=Taxes)
- Stimulating I, EG by cutting corporation tax.
- Increasing G, EG by starting new projects to make schools/roads/hospitals or improve education and training.
- Stimulating(X-M), EG by lowering exchange rate.

The problem is: All these options cost money, and the government debt is no joke. The most ‘cheap’ one would be the last option; by lowering the value of the GBP against other currencies to stimulate the exports. But there might be some troubles: The value of currencies is primarily determined by the market and the daily volume for those currencies are huge.

Therefore – to do serious interventions – the intervention itself must be Huge.

Another problem is that all those options will have time lags, some might take a few years to fully give its effect and the recession might be over by then…

So what will the optimal interest rate be?
I think the interest rate should be kept on the same level, a decrease would tend towards ZIRP of which I am not a proposer.