Question

Assume that there is no policy response to the increased saving by American families and consider the transition from the short-run to the medium-run (the medium-run is some intermediary or a transition state between the short-run and the long-run) and back to the long run. True or False. The US will see increased inflation during the transition back to long-run equilibrium. If true, explain why. If false, explain why not. (use the IS-LM and AS-AD logic to answer)

Answer 1

The statement is false.

Increase in saving decreases consumption, so IS curve will shift leftward, decreasing interest rate and decreasing GDP in short run. In medium run transition, expectations adjust and so, lower interest rate decreases the demand for money, shifting LM curve rightward. In long run equilibrium, interest rate is further lower but output restores to initial level.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output (real GDP) Y0. When savings fall, IS0 shifts left to IS1, intersecting IS0 at point B with lower interest rate r1 and lower GDP Y1 in short run. In medium run, LM0 shifts right to LM1, intersecting IS1 at point C with still lower interest rate r1 and restoring GDP to Y0.

Lower consumption decreases aggregate demand. When aggregate demand decreases, it shifts AD curve leftward and decreases both inflation and real GDP. In long run, expectations adjust, so aggregate supply increases, shifting SRAS curve rightward. In long run equilibrium, price level (inflation) is further lower but output restores to initial level.

In following graph, initial equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level (inflation) P0 and initial equilibrium real GDP (potential GDP) Y0. When saving increases, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. In medium run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring GDP to Y0.