Question

Which aggregate supply curve in Figure 14.7 does the Fed chairman fear the most? Why?

Answer 1

Answer

The shape of the aggregate supply curve: Aggregate supply curve is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceterius paribus. The aggregate supply curve may be horizontal shaped (Keynesian view), vertically placed (monetarist approach) or upward - sloped (eclectic view).

(1) The supply curve feared by the Fed: The Fed fears the vertical aggregate supply curve the most.

(2) Reason for fearing a vertical aggregate supply curve Fed fears the vertical aggregate supply curves the most. This is because such a supply curve means that the quantity of goods produced is primarily dependent on production capacity, labor - market efficiency, and other structural forces.

These structural forces establish a natural rate of unemployment that is fairly immune to short-run policy intervention. This implies that producers have no reason to depart from this natural rate of output when money supply increases. Hence rising prices will not create any new profit incentives for increasing output. Firms will continue producing at the natural rate, with higher (nominal) prices and costs. Thus, an expansionary monetary policy only causes inflation, leaving the level of output unaffected.