Question

Describe how changes in expected inflation impact an economy in the wake of a temporary negative supply shock.

Answer 1

A negative supply shock reduces output, which leads to decrease in market supply and cause a rise in demand and thus leads to price rise i.e. inflation.

Natural disasters and geopolitical developments such as war or terrorism can both cause supply shocks. The changes in expected inflation impact an economy in various ways such as- It erodes purchasing power because a fixed sum of money allows for progressively less consumption. Secondly it disproportionately harms the poor as- Lower-income consumers spend a higher proportion of their income overall and on necessities than higher-income consumers, providing less of a cushion against the loss of purchasing power caused by inflation.

Third it raises  Interest Rates-Governments and central banks both have a strong incentive to keep inflation under control. Over the last century, the approach in the United States and around the world has been to manage inflation through monetary policy , they gradually increase interest to keep inflation in check.

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