Question

Suppose that a law required the FED to do everything possible to keep inflation rate equal to zero. Using AD and AS curves, illustrate and explain how the Fed would deal with (a) a negative demand shock from a decrease in Investments and (b) an adverse aggregate supply shock. What would be costs and benefits of such a law?

Answer 1

Negative Demand Shock

The negative demand shock from a decrease in investment will shift the aggregate demand curve downward to the left from A₁D₁ to A₂D₂. The price level will decline from P₁ to P₂, while the output will decline from y₁ to y₂. In such a situation the Fed can boost the demand by increasing the supply of money.

Increased supply of money for a given level of income will ensure that people start to hold the extra money as speculative balances. To keep the money market in equilibrium the interest rate will fall as people invest their extra money into speculative investment.

Decline in the interest rate will boost the investment level in the economy as firms will find it cheaper to borrow for plants and machinery. As a result, the aggregate demand curve will again shift upward to the right to A₁D₁.

Adverse Supply Shock

An adverse supply shock will shift the aggregate supply curve upward to the left from A₁S₁ to A₂S₂. The price level will increase from P₁ to P₂, while the output will decline from y₁ to y₂. In such a situation the Fed can bring the economy back to the initial equilibrium with regard to zero inflation by following tight monetary policy. In other words, the Fed can reduce the supply of money, which will reduce the price level.

This is because when the money supply is reduced then, for a given level of income people have less money to finance their transaction needs. As a result, they start to withdraw from their speculative balances. To keep the money market in equilibrium the interest rate will increase.

Increase in the interest rate will cause the investment to decline as firms will find it expensive to borrow for plants and machinery. As a result, the aggregate demand curve will again shift downward to the left.