5.5 A negative (inflationary) supply shcok and the monetary policy dilemma

do demand shocks and supply shocks both present policymakers with a clear policy dilemma?

no - just supply shocks bc if they wish to bring inflation back on target they can only do so by policies that cause output and unemployment to fall

**supply shock i.e. higher input price

what happens with a supply shock i.e. higher input price?

PS curve hsifts down —> must be a cut in real wages

**negative supply shock

when does the policy dilemma arise w/ a neg supply shock

if the economy doesn’t automatically fix itself and shift down to higher unemployment

if not, this creates a positive bargaining gap, which means that a negative supply shock is inflationary and the phillips curve shifts upwards, leading to increased inflation

what is the dilemma?

voters don’t like it when inflation goes up or when employment goes down but the central bank can’t keep people happy on both accounts here

**in order to satisfy its objective, it has to eliminate the bargaining gap to stop inflation from rising further, which it does by causing employment to fall by lowering AD

how does the central bank solve this problem?

it only has one tool: nominal policy interest rate

it needs to raise this by enough so that real interest rates rise, meaning policy rate needs to rise by more than expected inflation and interest rates need to rise enough to shift AD curve down

what happens if the central bank delays its policy response?

the risk is that the rise in inflation will become embedded in inflation expectations. w/ unchanged level of employment, this shifts phillips curve upwards. the central bank could then decide to raise interest rates but this stabilizesinflation at a rate above target inflation and th ebank will just have to tighten policy further to bring inflation back to target

if forced to choose between employment and inflation, what will the central bank choose?

it will always choose inflation

are policymakers always able to stabbilize the economy

no, it’s often difficult to decide whether a downturn is a temporary blip or signifies a long-term weakness, or whether a rise in prices is indicatice of a supply shock or is restricetd to certain parts of the economy