FIGURE 14-10
A Reduction in Target Inflation A permanent reduction in target inflation in period
t shifts the dynamic aggregate demand curve to the left from
DADt–1 to
DADt, +t1, . . . . Initially, the economy moves from point A to point B. Both inflation and output fall. In the subsequent period, because expected inflation falls, the dynamic aggregate supply curve shifts downward. The economy moves from point B to point C in period
t + 1. Over time, as expected inflation falls and the dynamic aggregate supply curve repeatedly shifts downward, the economy approaches a new equilibrium at point Z. Output returns to its natural level
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, and inflation ends at its new, lower target (π
t*,
t+1, . . . = 1 percent).