Question

1.On a fully labelled AD/AS diagram, which shows that the economy is experiencing an inflationary gap, demonstrate what would happen if interest rates increase. Was the policy successful? 2.On a fully labelled AD/AS diagram, which shows that the economy is experiencing a recessionary gap, demonstrate what would happen if a new technology is introduced that makes workers more efficient.

Answer 1

1.On a fully labelled AD/AS diagram, which shows that the economy is experiencing an inflationary gap, demonstrate what would happen if interest rates increase. Was the policy successful:

Answer : Fig. below shows inflationary gap where aggregate demand has shifted right from AD1 to AD2. Price levels also go up from Pf to PLe. Real GDP goes up from Yf to Ye. Real GDP is more than potential GDP of Yf.

During an inflationary level, govt. can adopt contractionary fiscal policy(Raising tax rates and decreasing govt. spending) and central bank can have contractionary monetary policy ( raising interest rates and lowering money supply ).

Inflationary gap correction needs AD 2 to be shifted back to AD1.Contractionary monetary policy will decrease borrowing by people and investments by businesses as cost of borrowing goes up. Higher interest rates also encourage savings and hence AD2 shifts to AD1. This will reduce economic activity and needed result will be achieved. Similarly for monetary policy.

This policy is a widely used policy by central banks all over the world to correct inflation. It may create unemployment but is largely successful as it can take place without time lags and does not create crowding out effect.