1.5. Let's consider a case that has some similarities to Figure 16.2. We mentioned that it's difficult for the Fed to know what's really happening to the economy in real time. This is similar to the well-known "fog of war," where wartime news accounts often turn out to be exaggerations of the real story. In this que tion, the Federal Reserve thinks that consumer pessimism has pushed AD down by 10%, but in reality, the pessimism has only pushed AD down by 5%.

a. In the following figure, illustrate two AD curves: "AD with false shock" (AD-F to save room) and "AD with true shock" (AD-T).

Old Solow growth curve Inflation rate

('IT)

Solow growth rate Real GOP growth rate

b. If the central bank wants to use monetary policy to reverse a 10% shock to AD, it will have to raise money growth by 10%. Now draw two more AD curves on the figure above: "Fed react to false shock" (FR-F to keep it short) and "Fed reacts to true shock"

(FR-T).

c. Mter the central bank overreacts to the ex aggerated news reports of economic calam ity, what is the final result: Will real growth be higher or lower than before the shock hit? Will inflation be higher or lower than before the shock hit?