This year before a major earthquake adversely affected the production capacity in Nepal, the country's economy was working at its capacity level and inflation and growth rates were following their normal and stable paths at 2% and 4%, respectively. When the earthquake hit the country, the government of Nepal increased its expenditure to repair the damages this year and ensure that production capacity recovers next year. Government expenditure is expected to return to its normal path next year. Meanwhile, monetary policy is remaining unchanged. Assume that if there is any gap between the economy's actual GDP (as determined by the crossing point of IS and LM curves) and its production capacity, price adjustments would take three years to close the gap.
Consider the situation where the government had not increased its expenditure and where production capacity would have remained impaired both this year and next.
- What would have happened to the inflation rate this year?
- What would have happened to inflation rate next year as a result of lowered production capacity?
Now consider the actual situation where the government increased its expenditure and assumed that it is successful to repair the damages by next year and at that point the expenditure returns to its normal path.
- What would be the inflation rate next year in this case?