Question

If a centrral bank were required to target inflation at zero, then when there was a negative aggregate supply shock the central bank

a. would have to increase the money supply. This would move unemployment closer to the natural rate.

b. would have to increase the money supply. This would move unemployment further from the natural rate.

c. would have to decrease the money supply. This would move unemployment closer to the natural rate.

d. would have to decrease the money supply. This would move unemployment further from the natural rate.

Answer 1

There is a trade-off between inflation and unemployment in the economy. It is reflective of the inverse relationship between unemployment rates and inflation rates. The negative aggregate supply shock will cause the price level to rise due to reduced output. To counter this, the central bank will need to decrease the money supply and restrict the lending capacity of the banking system. In return, this would dampen aggregate demand in the economy. This contractionary shock would cause national output and employment to fall, leading to greater unemployment.

The natural rate of unemployment is the level of unemployment that is inherent in an economy due to social and technological frictions. The rate is devised taking into consideration people who are fresh out of college, people who are between jobs, etc. Such a situation as detailed above would lead others also to be unemployed, essentially pushing the unemployment rate away from the natural rate.

Thus the answer is D) Would have to decrease the money supply. This would move unemployment further from the natural rate.