Freezone, shown in Figure 14.1, the aggregate demand curve is AD, potential GDP

Question

Freezone, shown in Figure 14.1, the aggregate demand curve is AD, potential GDP is $300 billion, and the short-run aggregate supply curve is SASB.
1. What are the price level and real GDP? 2. Does Freezone have an unemployment problem or an inflation problem? Why? 3. What will happen in Freezone if the central bank takes no monetary policy actions? 4. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?
FIGURE 14.1 SASA ?140 ,200 N 130 120 ?101. g 100 SASB AD 0 100 200 300 400 500 Real GDP (billions of 2009 dollars)

Explanation / Answer

We are given that the potential GDP is $300 billion. Currently the short run AS is SASB

1. At the meeting point where AD and SASB intersect, the price level in the short run is 110 and real

GDP is $400 billion

2.The economy at this stage has an inflationary gap since potential output is less than current output.

Thus it has an inflation problem because at the potential GDP of 300 billion the price level described by

SASB is 100. Hence there is an inflation at a price of 110

3.In case the central bank takes no monetary policy actions, the short run aggregate supply SASB will

shift to the left. This would restore the original potential GDP level but increase inflation further

4. We advise the central bank to initiate a monetary contraction that shifts the AD to the left. This will reduce both GDP and price level which will restore the potential GDP and will result in a lower price level.

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