Demand Shock in Economy

The movements from A to E represent the reactions of the parameters due to the demand shocks (Mankiw, 2006). At period t+4 since the DAS curve continues to move downwards as a result of the low inflationary pressure in the period t+3. As the negative demand shock that is described in this situation persists the DAD curve returns to its actual position which is DADt-1, t+4, thus the economy moves to point F. Since the DAS curve is lower than it was earlier, so a recovery process will cause the curve to move upwards to point A. This may be due the rise in employment level or an increase in the wage rate by the workers in the economy or a general rise in the output level owning to the inflation prevailing in the economy. Source: Mankiw, 2006 Answer to question 2 As the economy undergoes a demand shock, the central bank responds immediately to combat the ill effects of such a shock. Generally in real case scenario the shock persists for several time periods. A negative demand shock calls for a fall in the output and the inflation level. Therefore the Central bank responds by lowering the level of interest rate. Now as the interest rate falls, so the level of goods as well as services demanded rises. Thus the contractionary effect of demand shock is offset. As the inflation level falls, so does the expected inflation level. As a result of the demand shock the nominal and the real rate of interest falls, however as the shock disappears the interest rate too increases (Mankiw, 2006). From the adaptive expectation rule we have Et (?t+1) = ?t, so Et-1 =?t, or ?t = 2% i.e. 2 The nominal interest rate is given as i= ?t + ? + ?? (?t –?*) + ?y (Yt – Y) i = 1.091+.02+0.5(1.091-0.2) + 0.5 (96.36 – 100) = -0.1745. Real rate of interest Rt =… As the economy undergoes a demand shock, the central bank responds immediately to combat the ill effects of such a shock. Generally, in real case scenario, the shock persists for several time periods. A negative demand shock calls for a fall in the output and the inflation level. Therefore the Central bank responds by lowering the level of interest rate. Now as the interest rate falls, so the level of goods, as well as services, demanded rises. Thus the contractionary effect of demand shock is offset. As the inflation level falls, so does the expected inflation level. As a result of the demand shock, the nominal and the real rate of interest falls, however as the shock disappears the interest rate to increases.Inflation targeting is basically an economic policy whereby the Central bank of the economy tries to project a targeted level of inflation and tries to drive the economy towards that level by using various monetary tools. If the prevailing rate of inflation is above the target then the Government raises its interest and the opposite happens when the inflation is below the target.A negative demand shock causes the inflation level of the economy to fall. Therefore the Central bank loosens the monetary policies so that the economy comes back to the targeted level of inflation, this further causes the economy to go back to the full employment level. Since the interest rate rises as the inflation are above the targeted level, this prompts the Central banks to go for inflation targeting.