The following diagram shows an economy in long-run equilibrium. Assume the equil

Question

The following diagram shows an economy in long-run equilibrium. Assume the equilibrium inflation rate is also the Fed’s targeted inflation rate.

The economy could be in a recession because of (A) a negative supply shock; and (B) a negative demand shock.
Suppose now there is a temporary aggregate supply shock.
(i) Describe how the AS curve in the diagram above is affected (e.g., a shift to the right, a movement up to the right on the given AD curve, etc.). Describe the temporary equilibrium inflation rate and aggregate output level, e.g., higher, lower, or the same as the original, etc.).
(ii) Suppose the Fed's main objective is to maintain a stable inflation rate, describe the policy action that is necessary to achieve this objective. How does the Fed's action affect the curve(s) in the diagram (e.g., AS shifts right, AD shifts left, etc.), and provide careful explanation.

(iii) Does the Fed's action conflicts with its dual mandate? Why or why not? Explain carefully.

Explanation / Answer

i. The AS will shift to the right., The temporary equilibrium inflation rate will lower and agggregate output level will be higher.

ii. To maintain a stable inflation rate an eefective Monetary policy action can be taken by FED.

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