5.3 Fiscal and monetary policy responses to demand shocks

supply-side equilibrium characteristics

(1) inflation rate = central bank’s target rate

(2) aggregate demand is at the level which maintains output and employment consistent with the top two panels

(3) wages and prices are aligned

**these people would not change their behavior here, there would be unemployment but this is inevitable and its level depends on supply-side policies

in real life, is it likely that all of the supply-side equilibrium things happen at the same time?

no

negative demand shock

fall in business confidence —> demand decreases —> output and employment decrease and multiplier process happens —> phillips curve shows that inflation also falls

**basically any time demand decreases

negative demand shock responses

inflation has fallen below its target

(1) monetary policy can be relaxed, interest rates can be reduced in order to stimulate AD enough to bring inflation back up towards target

(2) fiscal policy can be used to push output and empoyment back up

what strengthens the incentive to act w/ a neg demand shock

if lower inflation persists, phillips curve will shift down, possibly introducing the risk of deflation