Why do temporary negative supply shocks pose a dilemma for policymakers?

Short Answer

Expert verified

Negative supply shocks are destructive to the economy which is a dilemma for policymakers

Step by step solution

01

Step 1. Introduction

The framework established by the central bank in order to accomplish economic growth and stabilise the country's economy is known as monetary policy.

02

Step 2. Explanation

Temporary negative supply shocks raise inflation and unemployment rates, necessitating a contractionary monetary policy to lower inflation while choosing for an expansionary monetary policy lowers unemployment. The unemployment rate will rise as a result of contractionary monetary policy, whereas inflation will rise as a result of expansionary policy. As a result, negative supply shocks are destructive to the economy, and policymakers are stuck trying to figure out what monetary policy to use to stabilise economic activity and inflation.

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Most popular questions from this chapter

It can be an interesting exercise to compare the purchasing power of the dollar over different periods in history. Go to https://www.bls.gov/data/inflation_ calculator.htm to find the inflation calculator. Use this calculator to answer the following questions. a. If a new home cost \(125,000 in 2017, what would it have cost in 1950? b. The average annual household income in 2017 was about \)50,000. What would this income have been in 1945? c. An average new car cost about $25,000 in 2017. What would this car have cost in 1945?

d. Using your results from parts (b) and (c), did the purchase of a new car consume more or less of an average household’s income in 2017 than in 1945?

In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a “soft patch” in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary.

  1. How might fears of a zero lower bound justify such a policy, even if the economy was not actually in a recession?
  2. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

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?

. Why do activists believe that the economy’s selfcorrecting mechanism works slowly?

What nonconventional monetary policies shift the aggregate demand curve, and how do they work?

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