Short-run fluctuations in output and inflation arise from shifts in either the dynamic aggregate demand curve or the short-run aggregate supply curve.

a. A decrease in the central bank’s inflation target shifts the dynamic aggregate demand curve to the left.

i. In the short run, this decreases both output and inflation.

ii. It drives current inflation below expected inflation.

iii. In the long run, inflation and expected inflation fall to the new target as output returns to potential output.

b. A government expenditure increase shifts the dynamic aggregate demand curve to the right.

i. In the short run, this increases both output and inflation.

ii. It drives current inflation above expected inflation.

iii. To keep inflation from rising, monetary policymakers shift their reaction curve to the left, raising the real interest rate at every level of inflation.

iv. Unless the central bank’s target inflation changes, the economy eventually returns to its original long-run equilibrium point.

c. A negative supply shock shifts the short-run aggregate supply curve to the left.

i. In the short run, this decreases output and increases inflation.

ii. The rise of inflation initially drives expected inflation up, but both inflation and expected inflation then begin to decline.

iii. Unless the central bank’s target inflation changes, the economy returns to its original long-run equilibrium point.