Question

What is the effect, in the short-run, on inflation and unemployment if there is a negative demand shock (such as a significant decrease in wealth from … say, a decrease in housing prices)?

i) Therefore, based on your answer to the question above, IN THE SHORT-RUN, if the AD is moving around (and the AS is relatively stable) then will there be a trade-off between inflation and unemployment (ie, do they move in the same direction or do they move in opposite directions)? Explain.

ii) As a member of the Federal Reserve, what policy would you recommend in response to a negative AD shock, and what is the effect of that policy on inflation and unemployment?

Answer 1

Ans. Suppose the economy is initially in long run equilibrium with full employment output level, Y, price level, P and unemployment rate equal to the natural rate, u.

i) A decrease in wealth leads to decrease in consumption spending leading to decrease in aggregate demand shifting the AD curve leftwards from AD to AD’. This decrease in aggregate demand at given level of aggregate supply leads to decrease in price level from P to P’. Now, as price is lower, firms profit reduces, disincentivising them to produce the goods, therefore, quantity of goods supplied decreases and the new output level is Y’ which is less than full employment level of output. Thus, with lower level of output, firms layoff workers increasing the unemployment rate beyond the natural rate u to u’. Thus, with decrease in price level unemployment rises, hence, in the short run there is a tradeoff between inflation and unemployment.

ii) The FED should use monetary expansion as the response of the demand shock. This will lead to an increase in money supply and at given level of demand for money, this will push the interest rate down. The reduced interest rate will mean a decreased cost of borrowing inducing private investment in the economy leading to increase in aggregate demand shifting the aggregate demand curve to right back to AD. This will lead to increase in price level from P’ to P and output back to full employment level Y. This increase in output has lead to employment of more workers, decrease the unemployment rate back to natural rate of unemployment, u. Thus, this policy has lead to a decrease in level of unemployment but increase in price level.

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