Question

Suppose the Federal Reserve announces that they will permanently decrease the inflation target rate. (a) Graphically illustrate the impact the change in the target inflation rate using the dynamic model of aggregate demand (DAD) and aggregate supply (DAS). Assume that the economy is initially at long-run equilibrium. (9 Points) (b) Describe the transition of both output and inflation to the long-run equilibrium in words.

Answer 1

As central bank aims to reduce the inflation target rate. It will induce consumers to postpone their consumption such that they consume goods when price falls.

a) As consumers postpone their consumption, it will shift the aggregate demand curve to its leftward from AD to AD1 which will reduce the price level from P to P1 and output fall from Q to Q1 and shift the economic equilibrium from point A to B.

b) As prices of goods have reduces, producers will supply less of the goods in long run which will shift the supply curve to its left. It reduces the output level further and raise price to its initial level. It will shift the long run equilibrium to a level where less of the goods are produced and price is same until and unless government or Fed interfere in between to raise aggregate demand and take economy to its initial natural level.