Use the dynamic aggregate demand$$aggregate supply framework to show how a boom in equity prices might affect inflation and output in the short run. If the central bank is willing to allow a rise in its inflation target, what would the long$-$run impact be on inflation and output?

The boom in equity prices would decrease consumption and increase investment, leading to a movement down along the dynamic aggregate demand curve. In the short run, equilibrium inflation would fall and equilibrium output would rise $.$

a$.$ Describe the long$-$run impact on inflation and output if the central bank implicitly allows its inflation target to rise.

The rise of the inflation target implies that the central bank would not take action to offset the change in the demand curve. The economy would eventually self$-$adjust, with the long$-$run aggregate supply curve shifting to the left until long$-$run equilibrium is restored. At this point, the long run equilibrium level of output would be the same and inflation would be the same compared with their initial levels.

b$.$ Describe the long$-$run impact on inflation and output if the central bank retains its original inflation target.

If the central bank maintained its original inflation target, monetary policy would tighten sufficiently to offset the initial shift in aggregate demand, shifting the aggregate demand curve further to the right. Output and inflation would increase $.$

Instructions: On the graph below, drag the AD curve to the appropriate position to show the change in aggregate expenditure. Then, drag the SRAS curve to the appropriate position to show the change in short run aggregate supply.