Chapter 24, Problem 1LO

To determine

To explain and illustrate:

The policy tools that monetary policy makers can choose while dealing with conditions of aggregate demand shock, temporary supply shock and permanent supply shock.

Concept introduction:

Aggregate Demand Shock: A sudden and large change in the aggregate demand in the economy. This may be due to changes in the expectations about future income or employment trends; changes in the expectations about future inflation or deflation; shift in the structure of demand from domestic economy to foreign country or vice versa; and malfunctioning of financial sector.

Temporary Supply Shock: A supply shock is a sudden increase or decrease in the supply of goods and services in the economy leading to a sudden effect on the economy’s general price level. If due to the supply shock, there is no shift in the long-run aggregate supply curve, then the supply shock is temporary. In case of temporary supply shock, it is the short-run aggregate supply curve that shifts.

Permanent Supply Shock: If due to the supply shock the long-run aggregate supply curve shifts, then the supply shock is permanent.

Explanation of Solution

The long-run equilibrium income is at Y* with price level P*. As a result of the demand shock, the aggregate demand curve shifts leftward from AD1 to AD2. The economy is in equilibrium at a lower income level Y1 and lower price level P1. There exists a large excess capacity of Y1Y*. In this situation, there is a question whether the government should do anything or not. If the shock is small, then there is no need of policy response. The economy will adjust and will move towards long-run equilibrium. But if the shock is large then the policy makers can adopt counter-cyclical fiscal and monetary policies to deal with the condition. The government can start spending more; the monetary policy can become expansionary which in turn will lower the interest rate to stimulate the economy. The expansionary monetary policy will push the aggregate demand curve back to its initial position, thereby restoring the long-run equilibrium output. The adjustment is shown in the diagram below.

When there is a temporary supply shock, the policymakers encounter a trade-off between stabilizing inflation and enhancing economic activities. They can come up with three policy responses:

• No response
• Policy to stabilize the inflation in the short-run
• Policy to stabilize the economic activity in the short-run.

In case of permanent supply shock, the policymakers can either choose not to respond or initiate policies to stabilize inflation.

A permanent supply shock shifts the long-run aggregate supply curve to the left from LRAS1 to LRAS2 resulting in a fall in aggregate output level but a rise in the price level. To control the inflation, the monetary policymakers will tighten the monetary policy and thus push the aggregate demand curve leftward to AD3. This is how the economy is back to its old price level. The adjustments are shown in the diagram below.