According to an online article, the Reserve Bank of India lowered its key policy interest rate in early 2013 "to help support an economy set to post its slowest annual growth rate in a decade." The article notes that the central bank lists constraints to further interest rate cuts including the "risk that inflation could flare again."
a. Use the dynamic aggregate demand and aggregate supply model to show where the Reserve Bank of India expected the country's economy to be in 2013 without the interest rate cut, and indicate what the central bank is trying to achieve with the interest rate cut. Assume, for simplicity, that real GDP in India in 2012 equaled potential GDP.
b. Why might the Reserve Bank of India be afraid that additional interest rate cuts would cause inflation to increase?