Question

Assume that the economy is hit with successive positive demand shocks, lowering unemployment and inflation. What policy would the central bank pursue if the decrease in inflation lowered inflation below their target (assuming the CB is operating under an inflation rule for monetary policy).

Answer 1

This has to be understood first how a positive demand shock can decrease both inflation and unemployment.

Suppose the government of the country imposes a reduction in taxes rates – like income tax, sales tax, excise tax, etc. This increases purchasing power of consumers; it increases aggregate demand (AD) and the curve should shift to the right as AD1. This also increases supply facilities (like lower taxes of inputs); therefore, the short run aggregate supply (SRAS) should shift to the right as SRAS1.

Graph: Price level LRAS SRAS SRAS1 EO PO P1 E1 AD1 AD QO Q1 Real GDP E0 is the potential level of equilibrium, where LRAS, SRAS, and AD meet. The new equilibrium after the demand shock (taxes cut) is E1, where AD1 and SRAS1 meet. Real GDP increases to Q1, indicating a decrease in unemployment. Price level decreases to P1, indicating a decrease in inflation.

If the rate of inflation becomes too low (below the target), the CB has to take a policy that reduces the gap between SRAS and SRAS1, or increases the gap between AD and AD1, or both.

The CB should take an Expansionary Monetary policy. It includes a reduction in interest rates, purchase of government bonds in open market, etc. Any one policy could have been taken. This increases money supply in the market, which increases purchasing power, and a shift of AD curve to the right further. This policy should shift SRAS curve to left as well, since inputs prices increase. The net effect is the increase in price level in a way so that the target inflation could be achieved.