Question

Imagine that an economy is hit by a negative supply shock and show it on a diagram with inflation on the y-axis and GDP growth on the x-axis. Assume that the central bank responds by increasing the growth rate of money. Show what happens on the graph and explain the tradeoff faced by the central bank.

Answer 1

When there is a negative supply shock in an economy the aggregate supply curve shifts to the left and in the short run there is an increase in the price level and reduction in the GDP. This is shown by a movement from A to B

The central bank can accommodate for this shock but it faces a trade-off. It can stabilize the output by increasing the growth of money but this will increase the general price level and will result in higher demand pull inflation.

It can stabilize the price level by decreasing the money supply which is helpful in reducing the rate of inflation but it will also decrease the real GDP and increase the severity of recession. Therefore there is a trade-off between price stability and output stability under a negative supply shock