Question

If there is a negative temporary supply shock,

a.) Please explain ‘no policy response’ case.

b.) Please explain ‘policy stabilizes inflation in the short run’ case.

c.) Please explain ‘policy stabilizes economic activity in the short run’ case.

please short answer

Answer 1

a) A negative temporary supply shock will mean that the aggregate supply curve will shift lefwards. This will cause an increase in the price level and a fall in the quantity. In the no policy response case inflation will increase in the short run as the output level falls. Over time the economy will adjust itself and the prices will fall and take the economy back to the long run level.

b) In such a case a expansionery fiscal policy is needed to shift the aggregate supply curve back to the original level. This will be through a cut in taxes which will cause the level of aggregate supply to increase and the economy will come back to the original level of prices and quantity as the aggregate supply curve shifts rightwards.

c) The government in this case will include expansionery aggregate demand through a cut in taxes that will increase consumption and investment. This will cause the aggregate demand curve to shift rightwards and so the output level is stabilized at a higher level of prices.