In which situation will inflation fall the fastest?
A) A negative supply shock occurs, the dynamic aggregate demand curve is steep and so is the monetary policy reaction curve
B) A negative supply shock occurs, the dynamic aggregate demand curve is flat and so is the monetary policy reaction curve
C) A negative supply shock occurs, the dynamic aggregate demand curve is flat, and the monetary policy reaction curve is steep
D) A negative supply shock occurs, the dynamic aggregate demand curve is steep, and the monetary policy reaction curve is flat

Question

Quizplus · Accepted Answer

When a negative supply shock occurs, inflation tends to rise. However, if the dynamic aggregate demand curve is flat, it means that the economy is not very responsive to changes in price levels. At the same time, if the monetary policy reaction curve is steep, it implies that the central bank is able to quickly and decisively respond to changes in inflation. This combination of a flat demand curve and a steep monetary policy curve allows the central bank to quickly reduce inflation and bring it back to the target level. Therefore, choice C is the best answer as it combines a negative supply shock with a flat dynamic aggregate demand curve and a steep monetary policy reaction curve.

In Which Situation Will Inflation Fall the Fastest