Reference no: EM131203882

Suppose a shock that reduced production costs in the economy (a positive supply shock) affected equilibrium output and inflation in both the short run and the long run. Instead of waiting for this economy to return to long-run equilibrium, the central bank opted to use the positive supply shock as an opportunity to move to a lower inflation target. Illustrate and explain the impact of this change in the inflation target using an aggregate demand-aggregate supply diagram.

If the central bank uses the positive supply shock as an opportunity to lower its inflation target, the (rightward, leftward) shift in the (long-run aggregate supply, short-run aggregate supply, dynamic aggregate demand) curve in response to the shock will be followed by a (rightward, leftward) shift in the (long-run aggregate supply, short-run aggregate supply, dynamic aggregate demand) curve. In the long run, output will be (same, higher, lower) and inflation will be compared (same, higher, lower) with their levels before the shock.