Using the aggregate demand – aggregate supply model

The aggregate demand – aggregate supply model extends the basic Keynesian model introduced in the previous two chapters to allow for ongoing inflation. The basic Keynesian model is useful for understanding the role of spending in the short-run determination of output, but assumes that prices are fixed. The aggregate demand – aggregate supply model enables us to show how macroeconomic events and changes in macroeconomic policies affect inflation, as well as output, illustrating the difficult tradeoffs policymakers sometimes face.

Exploration: How do changes in economic events and economic policies affect output and inflation in the economy?

The window above illustrates the aggregate demand – aggregate supply diagram relating inflation and real output in the economy. Short-run equilibrium is determined by the intersection of the AD and SRAS curves, while long-run equilibrium is determined by the intersection of the AD and LRAS curves. The economy is in both short-run and long-run equilibrium to begin with. To use the graph, click near the green triangles and slide to move the AD or LRAS curves, or click near the AD arrows and slide to move the AD curve. Click the Self Correcting Equilibrium or AD Policy Adjustment buttons to move the economy to full-employment equilibrium; click the Reset button to restore the curves to their original positions.

1. Oil prices rose dramatically during the 1970s, creating an adverse inflation shock. Analyze the effects of higher oil prices on the economy. What happens in the short run to inflation, output, and the unemployment rate as a consequence of the increase in oil prices?
   
   
2. Suppose there is an adverse inflation shock in the economy. If there are no changes in monetary or fiscal policy, what will happen to inflation and output over time (in the long run)? If the Federal Reserve and the government respond to the inflation shock by changing monetary and fiscal policies to eliminate the resulting output gap, what will happen to inflation and output over time? Use your results to explain why inflation shocks pose a difficult dilemma for macroeconomic policymakers.
   
   
3. During the late 1990s the U.S. economy was booming due to an increase in consumer and business spending: output was at or beyond potential GDP and unemployment rates were falling to 30-year lows. How should the Federal Reserve respond in this type of situation?
   
   
4. The latest U.S. recession began in March, 2001, primarily due to a reduction in investment spending by businesses. According to the AD/SRAS/LRAS model, what are the short-term effects of a decline in investment spending? How should policymakers like the Federal Reserve, Congress, and the President respond to this type of change in autonomous spending?
   
   
5. According to the AD/SRAS/LRAS model, what causes rising inflation? How would you illustrate this using the model?
   
   
6. Use the AD/SRAS/LRAS model to explain how a sustained decline in aggregate spending could lead to disinflation – a substantial and ongoing reduction in the rate of inflation – something the Federal Reserve became concerned about in the spring of 2003.
   
   
7. Worker productivity increased significantly in the mid/late 1990s, a point made publicly on numerous occasions by Federal Reserve chairman Alan Greenspan. Use the AD/SRAS/LRAS model to illustrate the effects on inflation and output of a permanent increase in labor productivity that reduces the cost of production.
   

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