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?

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. Please show illustrations showing the movement of the AS and AD curves.

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

Explanation / Answer

1. A surprise increase in Investment Spending- A surprise increase in investment spending leads to increase in Aggregate demand which in turn lead to increase in price and output. Since we need to keep prices stable at P=100 and our desire is to eliminate the inflation.So the government can use contractionary fiscal policy or contractionary monetary policy to decrease Aggregate demand inorder to stabilize the price at P=100.

2. Catastrophic floods that causes a sharp food price increase-since catastrophic floods lead to decrease in the output and the increase in the price levels because of the decrease in the Aggregate supply in the economy .So government can follow contractionary fiscal policy or contractionary monetary policy so as to reduce the price level and to eliminate the inflation in order to stabilize the price at P=100.

3. A productivity decline that reduces potential output-since the productivity decline leads to reduction in the potential output and hence it leads to decrease in the prices .In order to stabilize P=100 .Government can use expansionary fiscal policy and expansionary monetary policy to increase Aggregate demand and hence it leads to increase in the price level and output.

4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States-A sharp decrease in net exports means decrease in the Aggregate demand which leads to decrease in the Price level as well as output. So in order to stabilize Price at P=100.Government can use expansionary fiscal policy or expansionary monetary policy in order to increase Aggregate demand.

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