Question

Over the previous year, suppose the unemployment rate has averaged around 5%, while
inflation has been around 2.5%. Recently, inflation started increasing, and currently
stands at 4%, while unemployment has fallen to 3.5% over this same period.
a) What sort of shock would generate these symptoms? Draw the AS/AD graph that
shows the state of the economy before and after this shock.
b) Briefly describe the two goals that the Federal Reserve is required to pursue with
monetary policy. Given these two goals, how will the Fed respond to this shock?
What specific open market operations will they pursue, and how will these actions
affect real GDP in the short run? You don’t need to discuss the size of the monetary
policy effects, just their direction – does Y increase, or decrease? Why?

Answer 1

(a)

Higher inflation and lower unemployment (due to higher GDP) indicates a positive aggregate demand shock, which has increased aggregate demand and shifted it rightward, increasing both price level and real GDP.

In following graph, AD0 and SRAS0 are initial aggregate demand and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As aggregate demand rises, AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

(b)

Fed's policy goals are to stabilize price level (inflation) and promote employment by lowering unemployment. However, these two goals are conflicting. If Fed intends to stabilize price level by lowering inflation, it will implement contractionary monetary policy by decreasing money supply, which, by raising interest rate, will decrease aggregate demand, shifting AD curve leftward and lowering price level. However, this policy will decrease real GDP as well, which will increase unemployment.