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)?

a) 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.

b) 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

A demand shock would reduce inflation and increase unemployment.
There is a trade-off between inflation and unemployment because when inflaiton rises, then unemploymnent falls and vice-versa.

I would increase money supply i.e expansionary monetary policy. This could be through purchasing government bonds or reducing reducing reserve rate. This would result in lower interest rate and hence increase investment and increase AD. Inflation would rise and unemployment would fall.

Please rate well.

answered by: anonymous