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

i) A Demand shock would shift the Aggregate Demand (AD) Curve to the left. In the short run, as a result of Aggregate Demand Curve shifting leftwards, the Price Level(Inflation) and Output would go down. Decrease in Output means Decrease in Employment and Increase in Unemployment. Thus, Inflation will go down and Unemployment will go up. They move in opposite directions. There is a trade is off between inflation and Unemployment in the short run.

ii) As a member of Federal Reserve, I would recommend increasing money Supply(Expansionary Monetary Policy) in the Economy using Open market purchase. This would lead to an Increase in Aggregate Demand. Thus, Aggregate Demand Curve would Shift rightwards. In the Short run, this will lead to an increase in Inflation and Output and employmemt. Thus, Unemployment will Decrease. Hence, an Expansionary Monetary Policy would, in the short run, Increase inflation and Decrease Unemployment.