Question

Graph 1

Draw an AD/SRAS/LRAS graph in initial long run equilibrium. Label the vertical and horizontal axes appropriately. Clearly identify the original price and real GDP level. On this graph, demonstrate what happens to the aggregate price level and real GDP when the Federal Reserve Bank runs expansionary monetary policy. Explain why you have shifted the curve you did and the direction you have shifted it. Identify whether the shift has caused a recessionary or inflationary gap.

Graph 2

Draw an AD/SRAS/LRAS graph that depicts an economy in an inflationary gap (we are not starting in initial equilibrium but in an inflationary gap). Label the vertical and horizontal axes appropriately. Clearly identify the original price and real GDP level. Shift the appropriate curve(s) to demonstrate what happens to the aggregate price level and real GDP when the economy is allowed to self-correct in the long run. Explain why you have shifted the curve you did and how this brings the economy back to long run equilibrium

Answer 1

In each graph, AD0, LRAS0 and SRAS0 are initial AD, long run Aggregate Supply curve and short run Aggregate Supply curves intersecting at point A with initial long run equilibrium price level P0 and real GDP (= Potential GDP) Y0.

GRAPH 1

An expansionary monetary policy increases money supply, which will increase aggregate demand and shift AD curve toward right, increasing both price level and real GDP which gives rise to an inflationary gap in short run. In the long run, higher price level will increase cost of input, so firms will decrease output and aggregate supply will reduce, shifting SRAS to left, and new long run equilibrium is at a further higher price but real GDP will be equal to potential GDP, eliminating short run inflationary gap. In following graph, as AD0 shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, causing inflationary gap equal to (Y1 - Y0) in short run.

GRAPH 2

A short-run inflationary gap leads to increase in price level, causing inflation. In the long run, higher price level will increase cost of input, so firms will decrease output and aggregate supply will reduce, shifting SRAS to left, and new long run equilibrium is at a further higher price but real GDP will be equal to potential GDP, eliminating short run inflationary gap. In following graph, economy is operating at AD1, which intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, causing inflationary gap equal to (Y1 - Y0) in short run. In long run, as SRAS0 shifts left to SRAS1, it intersects AD1 & LRAS0 at point C with still higher price P2 and real GDP is restored to potential GDP of Y0, eliminating the short run inflationary gap.