Question

The Financial Crisis, Long-Run Aggregate Supply and Inflation

In the fall of 2008, the financial markets suffered a major crisis that led to a large decrease in the willingness of banks and other financial institutions to lend either to each other or to consumers and businesses. Much of the investment in capital in the United States is financed by borrowing. Many businesses were unable to borrow. During this time period, the capital stock decreased as worn-out capital was not replaced.

What would the effect on the rate of inflation be if aggregate demand recovers to its prerecession level?

Answer 1

Due to the deviation from the long run equilibrium, the US economy had entered a recessionary gap.

In this situation, actual output is much less than potential. In the US economy's case, this occurred due to a drastic fall in aggregate demand. This fall took place because lending activities had stopped, and this led to a fall in consumption and investment.

This can be shown graphically as follows:

In the diagram, the economy has been deviated from long run equilibrium. The SRAS and AD intersect at less than potential GDP. Thus, (Y* minus Y) is the recessionary gap.

In the short run, equilibrium is at P and Y.

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Now due to the government's intervention, the economy had been brought back to long run equilibrium. This is done by shifting the AD curve to the right.

This is done by expansionary fiscal and monetary policy. This includes more government expenditures, less taxes, lower interest rates, and so on.

This is shown in the graph below:

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The trade-off here is that, to bring AD back to its pre-recession level, the government has to bear a much higher rate of inflation. As capital stock is worn out, it takes much longer for production to also rise.

As can be seen in the graph, due to the rightward shift in AD, the recessionary gap is closed. However, P rises to P", which is much higher.

To sum up, the rise in AD is associated with a rise in inflation.