Week 23 - Aggregate Demand, Aggregate Supply, Inflation Pt2 Flashcards
(31 cards)
How does increased military spending affect aggregate demand (AD)?
It increases AD, shifting the AD curve to the right.
What happens when output exceeds potential output (Y > Y*) due to increased AD?
An expansionary gap forms, leading to higher inflation (π increases).
How does the short-run aggregate supply (SRAS) curve respond to rising inflation?
It shifts leftward to SRAS’, as firms raise prices in response to higher costs and demand.
What is the long-run outcome after the SRAS shifts in response to inflation?
The economy returns to long-run equilibrium at potential output (Y) but with a higher price level (π).
How Did Inflation Get Started in the
1960s?
- In 1959-63 inflation averaged about 1%
- By 1970 inflation was 6%
- Fiscal Policy
– Increases in defense spending - 1962-65 = $70 billion
- 1968 = $100 billion
- Monetary Policy
– The Fed did not try to offset the increase in
government spending
What is an inflation shock?
A sudden change in the normal behaviour of inflation, unrelated to the nation’s output gap.
What is a key characteristic of an inflation shock?
It occurs independently of changes in output or the output gap.
Give an example of a historical inflation shock.
The OPEC oil embargo of 1973.
Give an example of a historical deflationary (negative) inflation shock.
The drop in oil prices in 1986.
What is the immediate effect of an adverse inflation shock on SRAS?
SRAS shifts leftward to SRAS’, increasing inflation (π’) and reducing output (Y < Y*).
What is the short-run equilibrium result of an adverse inflation shock?
The economy moves to point B: lower output (Y’) and higher inflation (π’) — this is stagflation.
What happens without policy intervention after an adverse inflation shock?
Inflation eventually falls, and the economy returns to long-run equilibrium at point A.
What is the effect of policy intervention in response to an inflation shock?
AD is shifted to AD’, restoring output to Y* but resulting in a permanently higher inflation rate (π*).
What is an aggregate supply shock?
It can be either an inflation shock or a shock to potential output.
What is a common effect of adverse aggregate supply shocks?
They reduce output and increase inflation.
How do shocks to potential output affect the economy?
They shift long-run aggregate supply (LRAS), lowering the economy’s capacity to produce at full employment.
What happens to potential output (Y*) in a shock to potential output?
Y* decreases, shifting the LRAS leftward to LRAS’.
What initial condition does the shock create in the economy?
Y > new Y*, resulting in an expansionary gap.
How does the short-run aggregate supply (SRAS) respond to this gap?
SRAS shifts leftward to SRAS’, increasing inflation (π rises).
What is the new equilibrium outcome after the shock?
The economy reaches equilibrium at point B, with output at the new Y*’ and a higher inflation rate (π’).
Is the decline in output from a potential output shock temporary or permanent?
Permanent — the economy adjusts to a lower potential output level.
What is the initial equilibrium in the short run before anti-inflationary policy?
At point A, where Y = Y* and inflation is 10%.
What action does the Fed take to reduce inflation?
It implements contractionary monetary policy, shifting AD to the left (to AD’).
What is the short-run result of the Fed’s action?
The economy moves to point B: Y < Y*, creating a recessionary gap.
