Question

A central bank has a new head, who decides to increase the response of interest rates to inflation. How does this change in policy affect the response of the economy to a supply shock? Give graphical answer and a more intuitive economic explanation.

Answer 1

Answer:

Effect of supply shock and hawkish interest rates. SRAS' LRAS SRAS R P R" E SRAD SRAD" OUTPUT Y" Y' Y Price O

The above graph shows the economy in the case of a supply shock and hawkish interest rates by the new Fed Chairman. The economy is in the long run equilibrium at point E and price level P. It is the point where Short run aggregate demand curve (SRAD) meets short-run aggregate supply curve (SRAS) with long-run supply curve (LRAS).

Due to the supply shock, the supply curve shifted to left (SRAS') meets the SRAD at point R where the prices are high and the economy is producing less than potential output Y' and the economy is at recession at R".

Now the new Fed chairman has increased the interest rates to cut the increased price i.e. inflation. This will have a very detrimental effect on the economy and the demand curve will shift to the left reducing demand further and reducing the output. After this deleterious move, the new output is Y".

Explanation: Supply shock occurs because of the increase in the price of inputs like oil. Because of this shock, the prices skyrocket and demand fall. The firms have to spend more on input and this increases the price of the product. If the Fed increases the interest rates then in such a scenario people will tend to reduce the demand further and would like to save the money, money saved will earn them higher interest now. Because of such move, the prices will come down slightly but the demand will suffer more and so will the output and the economy will move into recession.

The only way to come out of such situation is to reduce the supply cost and move the supply curve in the right direction reducing the cost and increasing the output.