Suppose we are initially at a long-run SP/LP equilibrium with x = p = pe = 4.Then an adverse supply shock adds 3 percentage points to the inflation necessary to produce each level of output.A "neutral" policy response ________ the level of nominal GDP growth so that inflation is ________ percent while (Y/YN)________.
A)lowers,4,falls
B)lowers,between 4 and 7,remains at 100
C)holds constant,between 4 and 7,falls
D)raises,4,remains at 100
E)raises,7,remains at 100

Question

Quizplus · Accepted Answer

In the initial equilibrium, x = p = pe = 4 and Y/YN = 100. 
After the adverse supply shock, the new equilibrium inflation rate would be 4 + 3 = 7%. 
To keep inflation at 4%, the policy response must be contractionary enough to reduce demand and output. However, since the shock has affected the economy's production capacity, output can no longer be sustained at the previous level of YN. As a result, the economy experiences a fall in the output level, causing Y/YN to also fall below 100. The only option that reflects this outcome is C, where the policy response holds nominal GDP growth constant (i.e., zero) and causes a fall in the output level while inflation remains between 4 and 7%.

Suppose We Are Initially at a Long-Run SP/LP Equilibrium with X