This graph shows an economy undergoing inflation. The initial state of the econo

Question

This graph shows an economy undergoing inflation. The initial state of the economy is represented by point A. Suppose that the economy moves from point A to point B and then back to point A. It then remains permanently at point A. This is a case of___. Suppose that the economy moves from point A to point B because of increases in costs of production. Assume that prices will rise periodically. The central bank decides to intervene and continually increase the money supply in an attempt to stabilize the economy. According to monetarists, what is the likely outcome of the central bank's intervention?

Explanation / Answer

1.

This is a case of temporary supply shock

2.

Correct option: (b) continued inflation

This is because the Central bank’s intervention to increase the money supply will shift the AD curve to the right to AD2.

The new equilibrium becomes Point D, which is associated with higher prices and same output.

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