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3) You observe inflation as well as output falling. Is it more likely that the economy...

3) You observe inflation as well as output falling. Is it more likely that the economy has been hit by a negative supply shock or negative demand shock? Explain.

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Answer #1

Inflation is generally caused by a high demand which can't be fulfilled at the current supply condition. This leads to a higher price which allows the firm to increase the price and reduce the unemployment in the economy. This happens in case of a positive demand shock. A negative demand shock will never cause an inflation.

But, when with rising inflation the output is falling this is because of a negative supply shock. It will increase the input cost in the economy and increase the price and decrease the output. The answer is Negative supply shock.

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