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?

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