Question

What would a central bank need to do to reverse the effects of a favorable supply shock on inflation? what would its reaction do to the unemployment rate in the short run?

Answer 1

A favorable supply shock is a sudden increase in supply that makes the short-run aggregate supply curve (SRAS) shift to the right, average price levels go down and real GDP also shifts to the right. In this case, average price levels go down as shown in the figure below from p1 to p2 SRAS shifts right.

This may make create deflation in an economy and discourage new producers to enter the market, to bring back inflation, the central bank may reduce interest rates and decrease the money supply in the market, and in short, will follow expansionary monetary policy. This will make people demand more and hence as aggregate demand shifts to correct average price levels may again go up. This move will create new jobs in the market as aggregate demand will increase in the short term.

A supply shock is an event that causes unexpected cost increases or production disruptions. This shifts the short-run aggregate supply curve to the left, boosting inflation and lowering real domestic production.

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