You are responsible for economic policymaking in your country. Your desire is to

Question

You are responsible for economic policymaking in your country. Your desire is to eliminate inflation, keeping prices absolutely stable at P = 100, no matter what happens to output. Currently, the economy is in equilibrium at Q = 3200 (where Q = potential GDP) and P = 100. You can use monetary and fiscal policies to affect aggregate demand but you cannot affect aggregate supply in the short run. How would you respond to the following scenarios?

1. A surprise increase in investment spending
2. Catastrophic floods that cause a sharp food price increase
3. A productivity decline that reduces potential output
4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States

Explain and illustrate how each of these events would affect aggregate demand, aggregate supply, and prices, then explain how you would respond with economic policies.

Explanation / Answer

1. This would move AD to the right so you would have to move it back to prevent an increase in the price level. You could do this by cutting government spending or raising taxes through fiscal policy, or by reducing the money supply (and increasing interest rates) with monetary policy.

2. This would move the supply curve to the left, so to counteract this you would have to move AD to the left, which you could do by one or more of the methods in answer 1.

3. Once again this would move the supply curve to the left so you would have to move the demand curve to counteract it. Use methods in 1 to do this.

4. This will move AD to the left so you could counteract it by expansionary fiscal or monetary policy, which is cutting taxes or increasing government spending, or increasing the money supply to lower interest rates. This would move the AD back to the right to keep the price level constant.

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