Question

Suppose the potential output growth of a country is actually 3 percent but policymakers erroneously believe that it is 5 percent and try to stimulate the economy persistently to achieve 5 percent growth. How would inflation and output move over time? Explain using the AD-AS and LRAS framework.

Answer 1

To achieve the 5% of growth rate, policy makers would adopt expansionary monetary policy in which they would increase the money supply in the economy by buying bonds. Suppose the economy is in equilibrium at point E where AD curve, AS curve and LRAS all intersects.Initial price level is P and potential output is shown by Yn. See the figure above.

In the short run, as money supply increases, AD curve shifts to the right. The new equilibrium is E' where both AD' curve and AS curve intersects.Both output and prices rises to Y' and P' respectively. But this cannot be equilibrium for long term because maximum potential output is Yn and Y'exceeds Yn. So over time, the adjustment of price expectations comes into play. As output is higher than the potential level of output, the price level is higher than wage setters expected. So they revise their expectations, which causes AS curve to shift upward over time. The economy moves up along the along the AD' curve. The adjustment process stops when output has returned to the potential level of output i.e Yn. Therefore in the long run AS curve shifts to AS" and equilibrium is found to be at A".At this equilibrium output is back to Yn and price level rise to P".

In such a scenario of targetting more than the potential growth economy could witness high inflation and obviously no changes in output.