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Chapter 24: Q.6 (page 655)

Why do temporary negative supply shocks pose a dilemma for policymakers?

Short Answer

Expert verified

Negative supply shocks are destructive to the economy which is a dilemma for policymakers

Step by step solution

01

Step 1. Introduction

The framework established by the central bank in order to accomplish economic growth and stabilise the country's economy is known as monetary policy.

02

Step 2. Explanation

Temporary negative supply shocks raise inflation and unemployment rates, necessitating a contractionary monetary policy to lower inflation while choosing for an expansionary monetary policy lowers unemployment. The unemployment rate will rise as a result of contractionary monetary policy, whereas inflation will rise as a result of expansionary policy. As a result, negative supply shocks are destructive to the economy, and policymakers are stuck trying to figure out what monetary policy to use to stabilise economic activity and inflation.

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Most popular questions from this chapter

Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and an estimate of the natural rate of unemployment (NROU). For the price index, adjust the units setting to 鈥淧ercent Change From Year Ago.鈥� For the unemployment rate, adjust the frequency setting to 鈥淨uarterly.鈥� Select the data from 2000through the most current data available, download the data, and plot all three variables on the same graph. Using your graph, identify periods of demand-pull or costpush movements in the inflation rate. Briefly explain your reasoning.

In what way is a permanent negative supply shock worse than a temporary negative supply shock?

In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a 鈥渟oft patch鈥� in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary.

  1. How might fears of a zero lower bound justify such a policy, even if the economy was not actually in a recession?
  2. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

For aggregate demand shocks and permanent supply shocks, the price stability and economic activity stability objectives are consistent: Stabilizing inflation stabilizes economic activity, even in the short run. For temporary supply shocks, however, there is a trade-off between stabilizing inflation and stabilizing economic activity in the short run. In the long run, however, there is no conflict between stabilizing inflation and stabilizing economic activity.

How does the policy rate hitting a floor of zero lead to an upward-sloping aggregate demand curve?
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