Using the Policy Interest Rate to Counter Supply-Shock Inflation

Central Bank Response to an Economic Shock

An economy experiences a sudden, sharp increase in the price of imported energy, leading to higher production costs for many firms and a rise in the general price level. If the central bank's primary mandate is to prevent this one-time price increase from developing into a persistent, accelerating wage-price spiral, which of the following describes the necessary policy adjustment and its direct effect on the labor market?

Analyzing a Central Bank's Response to a Supply Shock

Following a negative supply-side shock that pushes prices up, an inflation-targeting central bank intervenes to prevent a persistent wage-price spiral. Arrange the following events in the correct causal order to show how the central bank's policy works to stabilize inflation.

When an economy is hit by a negative supply shock, an inflation-targeting central bank can prevent a wage-price spiral from developing by reducing aggregate demand, a process that can be accomplished without any negative impact on the level of employment.

The Labor Market Link in Inflation Control

An economy experiences a widespread, unexpected increase in production costs, leading to a rise in the general price level. An inflation-targeting central bank intervenes to prevent this from turning into a persistent wage-price spiral. Match each component of this economic scenario with its correct description.

An economy is hit by an adverse supply-side event, causing an initial jump in prices. An inflation-targeting central bank decides to implement a policy that reduces overall spending in the economy. What is the primary economic rationale for this action as a method to prevent sustained inflation?

Following an unexpected event that raises production costs across an economy, an inflation-targeting central bank will enact policies to reduce overall economic demand. This reduction in demand is intended to cause a temporary fall in employment, which in turn eliminates the positive __________ and halts the pressure for further price rises.

Evaluating a Central Bank's Inflation-Fighting Strategy