Mario Draghi, President of the European Central Bank (ECB), released this statement:
Let me now explain our assessment in greater detail, starting with the economic analysis. Real GDP in the euro area rose by 0.2%, quarter on quarter, in the first quarter of this year. This confirmed the on- going gradual recovery, while the outcome was somewhat weaker than expected. [...] At the same time, although labour markets have shown some further signs of improvement, unemployment remains high in the euro area and, overall, unutilised capacity continues to be sizeable.
According to Eurostat's flash estimate, euro area annual [] inflation was 0.5% in May 2014, after 0.7% in April. This outcome was lower than expected. On the basis of the information available to us at today's meeting, [] inflation is expected to remain at low levels over the coming months [].
(a) Consider this information in the context of the aggregate supply and demand framework. Based on ECB President Draghi's statement, where is the short- run equilibrium of the economy relative to the ECB's inflation target (2%) and the long-run equilibrium level of output? Illustrate your answer with the appropriate diagram.
(b) Given your answer to (a), what should the ECB's response be? The ECB's benchmark interest rate? Illustrate in both an IS-MP diagram and an AS- AD-LRAS diagram.