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Suppose the economy is currently having an inflation expectation which equals to actual inflation. Explain how...

Suppose the economy is currently having an inflation expectation which equals to actual inflation. Explain how the output level will be affected in the short-run and long-run if there is a demand shock that drives the actual inflation to fall below expectation. (10%)

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Expert Solution

The actual inflation to fall below expectations, there should be a negative demand shock in the economy. It is going to decrease in the actual output in the short run where price level will decrease. It can be due to the decrease in wealth, recession in the economy or pessimistic economic outlook in the short run. Though, in the long run, output level, is going to be at the potential output level, at a lower price level. It will happen, due to SRAS curve shifting to the right, as a result of lower cost of production as wage rate decreases with more people unemployed in the short run. It happens due to auto-adjustment mechanism of the economy without any government intervention.

Rahul Sunny answered 2 years ago
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