Question

Consider a disinflation policy. Using an AS/AD diagram, explain the macroeconomic consequences of this shock, both immediately and over time.

A) Assume that the expected inflation is formed by adaptive expectations.

B) Assume that the expected inflation is formed by rational expectations.

Answer 1

A) If consumers have adaptoive expectations which means they changes their expectations as per the historical trend. If price are being reduced through disinflation policy, consumers will expect to a fall in price of the good they consume in short run which will shift aggregate demand of goods now because they will buy when price will fall more.

In long run when aggregate demand falls, producers will start producing less of the goods to remove inventories.

Both of these factors will shift economic equilibrium from point A to B (in short run and B to C (in long run)

B) If consumers have rational expectations, they will expect price to rise soon as they are falling consistentely. It will raise their aggregate demand in short run which will shift aggregate demand curve to its right in short run shiftin the economic equilibrium from point A to B.

In long run when demand is high, producers will produce more of the goods to raise their profit which will shift aggregate supply curve to its right from AS to AS1 which will shift the economic equilibrium frm point B to C.