Figure 5.8: Tightening Monetary Policy to Address a Negative Supply Shock

Central Bank Policy Response to a Supply Shock

An economy experiences a severe and persistent increase in the cost of raw materials, leading to a rise in the general price level above the central bank's target. To fulfill its mandate of stabilizing prices, what is the necessary course of action for the central bank, and what is the direct consequence of this action?

An economy is in equilibrium with stable inflation at the central bank's target. It then experiences a permanent negative supply-side shock (e.g., a lasting increase in the price of oil). Arrange the following events in the logical sequence that describes how the central bank would successfully return inflation to its target.

Evaluating Policy Responses to Supply-Side Inflation