Suppose central bank observes directly aggregate demand shocks or fully anticipates them. Formulate...

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Suppose central bank observes directly aggregate demand shocks or fully anticipates them. Formulate a monetary policy rule that would insulate the economy from aggregate demand shocks. This monetary policy rule would keep inflation at the target rate and GDP at potential (ie. on trend) when an aggregate demand shock hits the economy. Show how it would work in the context of the IS-MP diagram. How would this monetary policy rule depend upon the sensitivity of investment to the real interest rate?

David · Accepted Answer

Monetary policy 
Suppose central bank observes directly aggregate demand shocks or fully anticipates them, then 
the monetary policy rule that would insulate the economy from aggregate demand shocks would 
be to decrease the interest rates on loans borrowed with the view of implementing an 
expansionary policy which can be instrumental in reducing unemployment as well as stimulating 
demand in the economy.  
The appropriate monetary policy would be to decrease the interest rate and ensure appropriate 
levels of balance in the economy using combinations of fiscal and monetary policies that can 
help ensure better levels of  demand for loans, help increase the money circulating in the 
economy and also help control demand.  The monetary rule that can insulate the economy from 
aggregate demand shocks is the rule that there should be a change in the bank interest rates based 
on reaction to economic changes and change in demand and supply of money in the economy. 
T\his monetary policy rule would keep inflation at the target rate and GDP at potential (ie.

Suppose central bank observes directly aggregate demand shocks or fully anticipates them. Formulate a monetary policy rule that would insulate the economy from aggregate demand shocks. This monetary...

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