Assume that price level in the ABC Islands, a U. S. trading partner, increases signalling inflation in the economy. Using aggregate demand aggregate supply analysis, explain the impact of the increased price level on the United States economy. If the Federal Reserve wants to repair the effects on the U. S. economy noted above, identify a policy action it might undertake. Explain the impact of the Fed action on each of the following: output price level the international value of the U. S. dollar.

The effects of inflation in the U.S. trading partner, will pass through the U.S. economy in the form of exports: since the U.S. imports goods from ABC islands, the higher prices in the ABC islands will make imports from there more expensive, contributing to a small raise in inflation in the overall U.S. economy.

However, exports from ABC Islands are likely to be a small component of U.S. Aggregate demand, so the effect in overall inflation is likely to be small.

Despite this, the fed can step in and raise interest rates by contracting the money supply. This is contractionary monetary policy, and it is used when inflation is rising. It lowers the value of the U.S. dollar in international markets, but it increases output price level.