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Chapter 24: Q. 27 (page 656)

As monetary policymakers become more concerned with inflation stabilization, the slope of the aggregate demand curve becomes flatter. How does the resulting change in the slope of the aggregate demand curve help stabilize inflation when the economy is hit with a temporary negative supply shock? How does this affect output? Use a graph of aggregate demand and supply to demonstrate.

Short Answer

Expert verified

The diagram displaying the effect of inflation stabilization on the economic system and output is as follows:

When the financial system is hit with a negative supply shock, the aggregate demand curve flattens, implying a minor increase in inflation and a big drop in output, as shown in the graph above.

Step by step solution

01

Concept Introduction

Inflation refers to the sustained increase in the general price level. It causes th evalue on money holdings to decrease as the purchaisng power of money falls because of price rise.

02

Explanation

The diagram showing the effect of inflation stabilization on the economy and output is as follows:

Where,

- LRAS is the long-run aggregate supply

- SRAS is the short-run aggregate supply

- AD is the aggregate demand.

According to the graph above, when the economy is hit by a negative supply shock and the aggregate demand curve flattens, it indicates a moderate increase in inflation and a large drop in output. Because the aggregate demand curve is flatter, inflation is closer to its true level; but, exchange rate movement on output levels may exist.

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Most popular questions from this chapter

Why does the divine coincidence simplify the job of policymakers?

Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and an estimate of the natural rate of unemployment (NROU). For the price index, adjust the units setting to “Percent Change From Year Ago.” For the unemployment rate, adjust the frequency setting to “Quarterly.” Select the data from 2000through the most current data available, download the data, and plot all three variables on the same graph. Using your graph, identify periods of demand-pull or costpush movements in the inflation rate. Briefly explain your reasoning.

Suppose the current administration decides to decrease government expenditures as a means of cutting the existing government budget deficit.

  1. Using a graph of aggregate demand and supply, show the effects of such a decision on the economy in the short run. Describe the effects on inflation and output.
  2. What will be the effect on the real interest rate, the inflation rate, and the output level if the Federal Reserve decides to stabilize the inflation rate?

For aggregate demand shocks and permanent supply shocks, the price stability and economic activity stability objectives are consistent: Stabilizing inflation stabilizes economic activity, even in the short run. For temporary supply shocks, however, there is a trade-off between stabilizing inflation and stabilizing economic activity in the short run. In the long run, however, there is no conflict between stabilizing inflation and stabilizing economic activity.

For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a longrun equilibrium.

a. Consumers reduce autonomous consumption.

b. Financial frictions decrease.

c. Government spending increases.

d. Taxes increase.

e. The domestic currency appreciates.
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