Suppose the Target Rate of Inflation Is 3 Percent and Real

Essay

Suppose the target rate of inflation is 3 percent and real GDP equals potential GDP. Now, suppose a major oil-producing country decides to increase the supply of oil in order to discipline the other members of the oil-producing cartel. There is a sharp decline in the price of oil, and, in turn, the rate of inflation falls to 2 percent in the short run. The Fed views this decline in inflation as temporary and expects the price adjustment line to shift back up to 3 percent next year, which it does.