Use the aggregate demand-aggregate supply framework to show how a boom in equity
ID: 1166257 • Letter: U
Question
Use the aggregate demand-aggregate supply framework to show how a boom in equity prices might affect inflation and output in the short run. If the central bank is willing to allow a rise in its inflation target, by the central bank, what would the long-run impact be on inflation and output?
The boom in equity prices would (increase/decrease) consumption and (Click to select)increasedecrease investment, leading to a (rightward shift of /leftward shift of /movement down) along the dynamic aggregate demand curve. In the short run, equilibrium inflation would (rise / fall) and equilibrium output would (rise / fall) .
a. Describe the long-run impact on inflation and output if the central bank implicitly allows its inflation target to rise.
The rise of the inflation target implies that the central bank would not take action to offset the change in the demand curve. The economy would eventually self-adjust, with the (short-run aggregate supply / long-run aggregate supply) dynamic aggregate demand curve shifting to the (right / left) until long-run equilibrium is restored. At this point, the long run equilibrium level of output would be (the same / higher / lower) and inflation would be (the same / higher / lower) compared with their initial levels.
b. Describe the long-run impact on inflation and output if the central bank retains its original inflation target.
If the central bank maintained its original inflation target, monetary policy would (loosen / tighten) sufficiently to offset the initial shift in aggregate demand, (returning the aggregate demand curve to its initial position / shifting the aggregate demand curve further to the right ). Output and inflation would (return to their initial values / increase)
Explanation / Answer
The boom in equity prices would (decreases) consumption and (increase)investment, leading to a (movement down) along the dynamic aggregate demand curve. In the short run, equilibrium inflation would ( fall) and equilibrium output would ( rise) .
a. Describe the long-run impact on inflation and output if the central bank implicitly allows its inflation target to rise.
The rise of the inflation target implies that the central bank would not take action to offset the change in the demand curve. The economy would eventually self-adjust, with the (long-run aggregate supply) dynamic aggregate demand curve shifting to the ( left) until long-run equilibrium is restored. At this point, the long run equilibrium level of output would be (the same) and inflation would be (the same)compared with their initial levels.
b. Describe the long-run impact on inflation and output if the central bank retains its original inflation target.
If the central bank maintained its original inflation target, monetary policy would (tighten)sufficiently to offset the initial shift in aggregate demand, ( shifting the aggregate demand curve further to the right ). Output and inflation would ( increase)
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