Starting from long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, output immediately decreases as a result of a one-period positive supply shock because:
A) the central bank raises the nominal and real interest rates in response to the increase in inflation.
B) the higher prices generate a negative demand shock that reduces output.
C) the natural level of output falls in response to the increase in inflation.
D) the central bank increases the target rate of inflation in response to the increase in inflation.

Question

Quizplus · Accepted Answer

In the dynamic model of aggregate demand and aggregate supply, a positive supply shock typically leads to higher inflation. The central bank, aiming to stabilize inflation, may respond by raising nominal and real interest rates. Higher interest rates can dampen investment and consumption, leading to a decrease in aggregate demand and, consequently, a decrease in output in the short run.

Starting from Long-Run Equilibrium in the Dynamic Model of Aggregate