Question

Do temporary negative supply shocks place policymakers in a predicament? Explain why. Discuss the dilemma they may encounter when stabilizing inflation and economic activity.

Answer 1

Both inflation and the unemployment rate increase with negative supply shocks. The expansionary strategy must be followed to reduce the unemployment rate, which further raises inflation. On the other hand, pursuing an inflation rate reduction policy requires a policy of contraction, which further increases the rate of unemployment. Therefore, stabilization policy with negative supply shocks involves a trade-off between achieving the goals of stabilizing inflation and stabilizing real economic activity.

If a supply shock is temporary, policymakers face a short-term exchange between stabilizing inflation and economic activity Policymakers may respond to the temporary supply shock in three ways: – No policy response – Policy stabilizes short-term inflation – Policy stabilizes short-term economic activity