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

Inflation is a persistent rise in the price. This price rise reduces demand of commodities. So demand curve has a downward slope. On the other hand increase in price creates opportunity to earn more. So supply moves up and the curve slopes upward. At the intersection, the demand and supply are equal. In the diagram, long run aggregate supply is the same as observed in the intersection. So inflation rate of this intersection is the target rate of inflation.

Recession is a situation when inflation rate is low. It will happen, if demand decreases. Fall in demand will and price will make sell less attractive. Hence production will drop. Recession will set in. So for recession, demand curve has to shift to the left. It is known as negative demand shock.

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(i) Now it has been assumed that there is a temporary aggregate supply shock. It implies that supply curve will move to the left. So supply will fall and price will rise. As a result inflation rate will temorarily increase and aggregate output is lowered. It is shown below.

Note that in the above diagram supply curve AS1 has shifted to the left. As a result, inflation has moved up from Op1 to OP2 and equilibrium supply has reduced from OQ1 to OQ2.

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(ii) If Federals objective is to maintain a stable inflation rate, then it has to reduce inflation rate. It is possible by increasing the demand. Government can made it possible by increasing its investment in social welfare activities. In a low profit situation, no private investor will be ready to invest. So government has to come forward. This extra investment will increase income. So demand will rise. Profit will be earned. It will attract investors to come forward. Gradually economy will come out from depression.

Also it is possible by lowering tax rate. It will increase disposable income. It is the excess of total income over tax paid. This amount is availale for consumption. Higher income will mean higher demand. So demand curve will shift to the right and recession will be controlled.

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(iii) Reduction in tax reduces revenues of government. So opportunity to invest more is reduced. Thus tax reduction and government investment increase becomes conflicting. If federal wants to increase government expenses, then it has to increase revenues to get investment fund. But it is not possible by reducing tax.

This dual conflicting nature of fiscal policy will create temporary adverse balance in the budget. But in the long run this problem will be solved by improving demand and supply and reducing inflation. Remember, governments basic objective is to maximize social welfare. This policy will help the federal to achieve it.

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