Suppose we are initially at a long-run SP/LP equilibrium with x = p = pe = 4.Then an adverse supply shock adds 3 percentage points to the inflation necessary to produce each level of output.An "extinguishing" policy response ________ the level of nominal GDP growth so that inflation is ________ percent while (Y/YN)________.
A)lowers,4,falls
B)lowers,between 4 and 7,remains at 100
C)holds constant,between 4 and 7,falls
D)raises,4,remains at 100
E)raises,7,remains at 100

Question

Quizplus · Accepted Answer

An adverse supply shock increases the inflation necessary to produce each level of output. This means the Phillips curve will shift up, and the new equilibrium will occur at a higher inflation rate for the same level of output.

Since the policy response is "extinguishing," we can assume that the central bank will lower the level of nominal GDP growth to bring down inflation to 4%, which was the initial level of inflation.

This means the central bank will reduce the growth rate of nominal GDP relative to its potential level. Since the initial equilibrium was at Y/YN=100, we can expect Y/YN to fall as a result of the policy response.

Therefore, the best choice is A, which states that the policy response lowers the level of nominal GDP growth so that inflation is 4 percent while (Y/YN) falls.

Suppose We Are Initially at a Long-Run SP/LP Equilibrium with X