Question

As monetary policymakers become more concerned with inflation stabilization, the slope of the aggregate demand curve becomes flatter. How does the resulting change in the slope of the aggregate demand curve help stabilize inflation when the economy is hit with a temporary negative supply shock? How does this affect output? Use a graph of aggregate demand and supply to demonstrate.

Short answer

The diagram displaying the effect of inflation stabilization on the economic system and output is as follows:

When the financial system is hit with a negative supply shock, the aggregate demand curve flattens, implying a minor increase in inflation and a big drop in output, as shown in the graph above.

Step-by-step solution

Concept Introduction

Inflation refers to the sustained increase in the general price level. It causes th evalue on money holdings to decrease as the purchaisng power of money falls because of price rise.

Explanation

The diagram showing the effect of inflation stabilization on the economy and output is as follows:

Where,

- LRAS is the long-run aggregate supply

- SRAS is the short-run aggregate supply

- AD is the aggregate demand.

According to the graph above, when the economy is hit by a negative supply shock and the aggregate demand curve flattens, it indicates a moderate increase in inflation and a large drop in output. Because the aggregate demand curve is flatter, inflation is closer to its true level; but, exchange rate movement on output levels may exist.