Assume that price level in the ABC Islands, a U. S. trading partner, increases signaling inflation in the ABC Island 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:

a. Output
b. Price level
c. The international value of the U. S. dollar

Answer is given below :

Explanation:

Inflation on ABC Island makes goods produced by ABC Island more expensive and makes goods made in the US cheaper. Thus the demand for goods made in the US will increase, the US export demand will increase, thereby the US net exports will increase and the US total demand will increase. The AD curve increases the real, shift price level and real GDP in the US economy. The unemployment rate will fall and demand for the US dollar will rise, causing the dollar to appreciate.In the following graph, the initial equilibrium is at point A, where AD0 (total demand) and SRAS0 (low-run total supply) intersection curves, equilibrium price levels P0 and true GDP Y0. As total demand increases, AD0 shifts to the right of AD1, blocking SRAS0 at point B with high P1 and high true GDP Y1. high total demand leads to inflation, the Fed wants to reduce inflation by reducing total demand. This can be done by using a contract monetary policy, by raising the required monetary ratio, by raising the discount rate, or by selling federal securities on the open market. Any of these tools will reduce the money supply, thereby increasing interest rates, reducing investment and reducing total demand. As a result,Output will decrease.Price will decrease.Low production reduces US import demand, thereby reducing foreign exchange demand. Foreign currency depreciation and the US dollar are appreciated.