Question

Suppose that there is a positive aggregate demand shock and the central bank commits to an...

Suppose that there is a positive aggregate demand shock and the central bank commits to an inflation rate target. If the commitment is credible, then

A) the public's expected inflation will remain unchanged.

B) the short-run aggregate supply curve will not shift.

C) over time inflation will fall back down to the inflation target.

D) all of the above.

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Answer #1

Correct option is (D).

A positive aggregate demand shock increases aggregate demand, shifting the AD curve rightward, which increases price level, and inflation rises. If commitment of inflation rate target is perceived as credible, individuals and businesses expect price level to remain unchanged in future, believing that Central bank will take steps to restore inflation rate to the target inflation rate over time. Therefore, firms will not change short run aggregate supply, and SRAS will not shift.

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