Consider the following \(A D / A S\) diagram. Suppose the economy experiences a negative aggregate supply shock-say, an increase in wages driven by a major union settlement. This reduces real GDP to \(Y_{1}\).

a. Explain what happens if the Bank of Canada does not react to the shock. Show this in the diagram.

b. Now suppose the Bank decides to offset the shock's effect on real GDP-that is, it validates the shock. Explain how this is possible, and show it in a diagram.

c. What danger do many economists see in validating such supply shocks? What is the alternative?

Transcribed Image Text:

Price Level 0 Y* Real GDP ADO AS AS