Question

For each question, choose the correct response (NO explanation needed!) A1. [10 marks] In the classical model, the economy is in long-run equilibrium where the equilibrium inflation rate is equal to the target inflation rate. The economy suffers an adverse supply shock (such as a permanent increase in the price of raw materials). In the new equilibrium: (a) Equilibrium inflation is below the target inflation rate and the government needs to loosen monetary policy to achieve its target. (b) Equilibrium inflation is above the target inflation rate and the government needs to tighten monetary policy to achieve its target. (c) Equilibrium inflation is below the target inflation rate and the government needs to tighten monetary policy to achieve its target. (d) Equilibrium inflation is above the target inflation rate and the government needs to loosen monetary policy to achieve its target.

Answer 1

(B) equilibrium infation is above the target inflation rate and government need to tighten monetary policy to achieve its Target.

A supply shock will decrease the production in short run as the supply curve will take a leftward shift this will result in fall in supply and create a excess demand . This excess demand will increase the inflationary pressure. So to manage this the government has to reduce the demand by tightening them