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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.

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Expert Solution

If expected Inflation is at its actual inflation, economy is at point A.. Price at this level is P and output level is Y. Negative demand shock will shift aggregate demand curve from AD to AD1 in short run which educe the price level from P to P1 and output level to fall from Y to Y1 which drives inflation to fall below natural level of inflation.

As demand falls in short run, producers will reduce their supply to avoid inventories in long run which will shift the supply curve from AS to AS1 which will raise the price back to its initial level which takes inflation level to its initial level and cause output to fall further to Y2 level.

Rahul Sunny answered 1 year ago
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