Question

How does a credible nominal anchor help improve the economic outcomes that result from a positive aggregate demand shock? How does a credible nominal anchor help if a negative aggregate supply shock occurs? Use graphs of aggregate supply and demand to demonstrate.

Short answer

The impact of a credible nominal anchor on the economic results of a positive aggregate demand shock, as well as the impact of a credible nominal anchor on the economic consequences of a negative aggregate supply shock.

Step-by-step solution

Step 1. Concept of nominal credible anchor

A nominal credible anchor is a system in which a country's credibility is increased by using a fixed exchange rate with gold, silver, or another country's currency (pegging). It is a method designed to lower public expectations of future inflation increases.

Step 2. Explanation

The graph depicts a positive demand shock.

As can be seen in the graph above, a positive demand shock causes an increase in demand, which causes the demand curve to move rightward, causing inflation to rise in tandem with the increase in output. Without a credible nominal anchor, a positive demand shock will raise expected inflation, causing the supply curve to collapse and inflation to rise even faster as output falls. However, if there is a credible nominal anchor, expected inflation will remain stable and controlled, and the only increase will be due to the shock, not to changes in supply or public expectations.

Step 4. Explanation

The graph depicting a negative aggregate supply shock is as follows:

As can be seen in the graph above, a negative supply shock causes a fall in aggregate supply, which raises inflation and lowers output. Without a credible nominal anchor, projected inflation would rise, but with a credible nominal anchor, expected inflation will remain steady and controlled, and the aggregate supply curve will not shift much. As a result, with a credible nominal anchor, the supply curve will shiftless, resulting in a lower level of inflation.

As a result, the credible nominal anchor helps to reduce projected inflation and keep the rate of inflation under control.