The Volcker Disinflation (1980-1986 ) was costly in terms of output and unemployment. Would it not have been better to reduce inflation with a positive supply shock, rather than a negative demand shock?
What will be an ideal response?
Probably, but a positive supply shock is a difficult to achieve policy goal. A permanent supply shock — shifting the long-run aggregate supply curve to the right — would require an increase in potential output, which is not a policy variable in the short run. A temporary supply shock was, in fact, attempted: public declarations of anti-inflationary intent to lower expected inflation. Though temporary, such management of expectations would result in a permanent decrease in inflation, since the consequence would be to move the economy to (rather than away from) potential output. In practice, the best one might hope is that adjustment of expectations in the wake of a negative demand shock will reduce the intensity and duration of the declines in output and employment.
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Refer to the diagram, in which Q f is the full-employment output. If the economy's present aggregate demand curve is AD 2 :
A. the most appropriate fiscal policy is an increase of government expenditures or a reduction of taxes.
B. the most appropriate fiscal policy is a reduction of government expenditures or an increase
of taxes.
C. government should undertake neither an expansionary nor a contractionary fiscal policy.
D. the economy is achieving its maximum possible output.
Suppose that the Fed decides to decrease the growth rate of the money supply in the United States. What is most likely to happen to the U.S. trade deficit and to GDP?
A. The trade deficit will fall; GDP will fall. B. The trade deficit will rise; GDP will rise. C. The trade deficit will fall; GDP will rise. D. The trade deficit will rise; GDP will fall.