Question

Prior to the 1980 presidential election, Candidate Reagan emphasized a supply-side approach to dealing with the inflationary problem. Using the AD-SRAS-LRAS, show and explain how a supply-side approach to lowering inflation (putting downward pressure on the price level or P) was supposed to operate.

Answer 1

Inflationary problem occurs when aggregate demand increases such that real GDP exceeds potential GDP, causing an inflationary gap. A supply-side approach attempts to increase aggregate supply, by providing favorable business regulations, tax schemes and incentives to firms, such that SRAS shifts rightward, thus decreasing price level and further increasing real GDP.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at initial long-run equilibrium point A with initial long-run equilibrium price level P0 and real GDP (potential GDP) Y0.

When aggregate demand rises, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, creating inflationary gap of (Y1 - Y0).

An effective supply side policy that boosts aggregate supply shifts SRAS0 rightward to SRAS1, intersecting AD1 at point C with initial price level P0 and higher real GDP Y2.