a. Initially it increases from 5.4% to 11.4%.

After that, it falls to around 6-7 and hovers there for a

few years, then it finally stabilizes at around 5% in the later years.

b. Food items and non-food items likely occupy a different proportion of spending for average

families in Bangladesh. Food items probably account for a fairly large % of spending among

average families in Bangladesh while non-food items probably account for relatively less;

however data is not given on this and all we can is assume the proportion of total family spending

is “different” and thus price changes are weighted differently when computing the CPI.

c. One domestic consequence of inflation is the wage price spiral in which inflation causes workers

to negotiate for higher wages which in turn causes a more expensive cost of production which

creates further inflation. This results in self-reinforcing inflation which can “spiral” out of control.

One external consequence of inflation is that it will probably cause our currency to depreciate.

This is because when our currency is inflating, people on the foreign exchange market want to

hold it less and don’t want to hold financial assets denominated in this currency. This manifests as

less demand for the currency and thus a lower eq’m price. This can then result in further inflation

as a depreciating currency can then cause an increase in export revenue and a fall in import

spending, leading to higher AD and even worse demand pull inflation.

d. Through the wage price spiral mentioned above, an increase in wages can result in higher demand

pull and cost push inflation. Observe in the diagram an initial increase in wages results in the

SRAS curve shifting to the left causing cost-push inflation. This results in higher incomes for

consumers which can then boost aggregate demand. This higher AD leads to even higher price

levels. With higher price levels, workers are likely to negotiate for higher wages and because at

this high level of output the amount of unemployed workers is fairly scarce, this means the

workers will likely receive those higher wages and thus we’ll have more demand pull inflation as

well. (Draw a neo-classical diagram and show the SRAS decreasing and AD increasing, price

level up)

e. Whether monetary or fiscal policy is a better solution for inflation depends on the time-frame and

whether or not the increase in price levels is acute or sustained. In the case where inflation comes

rapidly and may not be permanent, fiscal policy is likely the better tool. In the case where inflation

maybe comes on less rapidly but is sustained and lasts a long time, monetary policy might be the

more effective solution.

Both types of policy are subject to “time lags”. It takes time for policy makers to identify the

problem, create policy, have it implemented, and have it actually impact macroeconomic

variables. Generally, changes in AD because of fiscal policy happen more quickly but also
fade more quickly; in the case of demand pull inflation resulting from random variation in

AD, fiscal policy is probably the most effective solution. AD is self correcting in the long run

and the fiscal policy can tackle the problem quickly while having a less permanent impact on

AD itself. However, in the case of more sustained inflation, a more measured approach that

takes longer to see results from but has more permanent results might be a better option.

Monetary policy involves changing interest rates throughout the banking and financial sector

to encourage saving and discourage borrowing and spending with the goal of reducing

aggregate demand so that price levels can fall. Generally, this means raising interest rates

(lowering the money supply) to achieve this; with a higher interest rate, consumers have less

incentive to borrow and more incentive to save. This results in less spending, less aggregate

demand, and a lower price level (diagram optional). By contrast, fiscal policy decisions would

involve raising taxes or lowering government spending; either of these would have a very

quick impact on aggregate demand whereas changing reserve requirement ratios with the goal

of raising interest rates to eventually effect change in consumer spending, saving, and

borrowing behaviour might take several years.

For the above reasons, for rapid onset inflation that is believed to be transitory, fiscal policy is

the better and faster solution. However, in the case where inflation is expected to be sustained,

monetary policy is a better solution.