100%(6)6 out of 6 people found this document helpful
This preview shows page 19 - 20 out of 20 pages.
38. Suppose the economy is in an inflationary gap, as illustrated by point A in the diagram below: Suppose that everyone knows that inflationary gaps lead to cost pressures that will eventually result in theprice level rising. Since people expect the price level to rise soon, suppose they increase their buying now(before prices rise). Demonstrate graphically and explain verbally how this will complicate the economy'sadjustment story described in the text. Answer: When there is an inflationary gap wage, the increase in wage costs result in an upward shift of the SAScurve (from SAS0to SAS1in the diagram below). The increase in the SAScurve will move the economy toa new equilibrium point B with the gap closed but with a higher price level (P1> P0). However, if peoplebuy now before the price level rises to P1the first thing that happens is that ADwill increase from AD0toAD1. This makes the inflationary gap worse! The economy goes from equilibrium point A to point C andthe inflationary gap grows from (Y1– Y0) to (Y2– Y0), with higher price level (P2). This means that thereare even greater pressures on firms than before so wages and costs will be driven even higher resulting ina shift up of SASnot to SAS1but rather to SAS2. Thus we go from point C up to point D. At point D theinflationary gap is closed since real output is at the potential output level of Y0. However the price level ismuch higher than it was when we started (P3> P0).Colander's Macroeconomics140
Chapter 10: The Aggregate Demand-Aggregate Supply Model39. Explain verbally and demonstrate graphically how in an AS/AD model with dynamic feedbackeffects, a decline in the price level can lead to a vicious downward spiral.