Question

9. Draw two separate graphs that show the Fed’s response in the case of a short-run aggregate supply shock, one in the case of prioritizing inflation and the other in the case of prioritizing output stabilization, in the AS-AD framework. Briefly explain the steps involved in the Fed’s monetary response.

Answer 1

Ans

First assume its aim is inflation stabilisation. Suppose that economy is initially in equilbrium at A. Due to supply shock shock run Aggregate supply shifts to SRAS and new equilbrium is at B where there is high inflation but low output. Now fed would like to reduce inflation and keep it below or at p. To do so it implements contractionary monetary policy which shifts AD leftwards to AD. New equilbrium is at C where inflation has decreased but output has reduced further resulting in greater unemployment. See fig 1

Here fed will sell securities or increase required reserve ration or discount rate. This raise cost of funds to commercial banks which increase their own lending rates resulting in lower C and I. Hence AD decreases

2 Now assume that fed prioritizes output. Fig 2 is similar to fig 1 except that here fed uses expansionary monetary policy to shift AD rightwards to AD so that full employment output Yf is restored back. But it results in greater inflation.

To do so fed will either purchase securities through open market operations, or reduce reserve ratio or bank rate. This will decrease cost of funds to banks who will inturn decrease their lending rates resulting in higher investment and consumption so that AD shifts to AD1