When the Fed reacts to a positive aggregate demand shock, which of the following is likely to make the period of disinflation shorter? I. credibility on the part of the Fed II. higher uncertainty about investment returns III. greater nominal wage flexibility
A) I and II only
B) II and III only
C) I and III only
D) I, II, and III

Question

Quizplus · Accepted Answer

Credibility on the part of the Fed would help to anchor inflation expectations and reinforce the disinflationary effects of the positive aggregate demand shock, making the period of disinflation shorter. Greater nominal wage flexibility would help to facilitate adjustments in the labor market that would help to contain inflationary pressures. However, higher uncertainty about investment returns could create a wait-and-see attitude among firms and delay the response of the economy to the positive aggregate demand shock, which could prolong the period of disinflation.

When the Fed Reacts to a Positive Aggregate Demand Shock