Suppose velocity is stable, What would the Federal Reserve need to know in order to keep output at its natural level following a supply shock?
In order for the Federal Reserve to keep output at its natural level following a supply shock, there are several key factors they would need to consider. Here's what the Federal Reserve would need to know:
1. Identify the nature of the supply shock: The Federal Reserve would need to understand the specific type of supply shock that has occurred. Supply shocks can be classified as either positive or negative. Positive supply shocks increase the economy's productive capacity, such as technological advancements or improvements in productivity. Negative supply shocks reduce the economy's productive capacity, such as a sudden increase in oil prices or a disruption in the supply chain.
2. Assess the impact of the supply shock on production: The Federal Reserve would need to evaluate how the supply shock affects the economy's overall production. They would need to consider whether the shock has decreased or increased the potential output of goods and services, and to what extent.
3. Analyze the impact on inflation: Since the velocity of money is assumed to be stable, the Federal Reserve would need to understand the effect of the supply shock on inflation. A negative supply shock can typically lead to higher prices due to reduced supply, while a positive supply shock may lead to lower inflationary pressures.
4. Evaluate the role of expectations: The Federal Reserve would also need to consider the impact of supply shock on expectations. If businesses and consumers anticipate that the supply shock will have a prolonged and significant effect on the economy, it can influence their behavior and decision-making, affecting output levels.
5. Implement appropriate monetary policy: Based on their analysis, the Federal Reserve would then need to adjust monetary policy to maintain output at its natural level. If the supply shock reduces output, they may need to consider expansionary policies such as lowering interest rates or implementing quantitative easing to stimulate demand. In the case of a positive supply shock, they may focus on tightening monetary policy to prevent overheating and potential inflationary pressures.
By thoroughly understanding these factors and their interplay, the Federal Reserve can take appropriate actions to mitigate the undesirable effects of a supply shock and help steer the economy toward its natural level of output.