Let€™s consider a case that has some similarities to Figure 35.2. 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 €œfog of war,€ where wartime news accounts often turn out to be exaggerations of the real story. In this question, 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 figure below, illustrate two AD curves: €œAD with false shock€ (AD-F to save room) and €œAD with true shock€ (AD-T).

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: €œFed reacts to false shock€ (FR-F to keep it short) and €œFed reacts to true shock€ (FR-T).
c. After the central bank overreacts to the exaggerated news reports of economic calamity, 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 hits?

Old Solow growth rate Inflation rate Old SRAS AD Real GDP growth rate Solow growth rate