Because deflation is so costly, some have argued that setting an inflation target at 2 percent is too low and it should be set higher, to 3 percent, especially in the economic environment of 2007-2010. Consider the impact of such an increase in the inflation target using the AS/AD framework in the short and long runs. Begin your analysis in the long-run equilibrium." Between the third & fourth quarters of '06, the housing bubble burst in the United States. Using the AS/AD framework to discuss the impact of this macroeconomic event, begin and end in the long run.

Explanation:

Considering the graph in the attached image, at point A, the economy was in the equilibrium, after an increase in the inflation target, the Ad curve will shift to the AD2. At this point the price is P* and the output is Y'. The new equilibrium is At B.

In the scenario given in the question, the worker will demand a higher wage as the real wages decline.

An increase in the wage will act as a negative supply shock and the demand curve will shift to the left i.e. SRAS2. The output will decrease and the price will increase. The new output will be at Y and equilibrium at C.

Therefore, increasing the inflation target will only increase the demand in the short run, and only increase the price in the market in the long run.