Suppose the economy is in an inflationary gap as illustrated by point A in the

Suppose the economy is in an inflationary gap as

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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 the price 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's adjustment 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 SAS curve (from SAS 0 to SAS 1 in the diagram below). The increase in the SAS curve will move the economy to a new equilibrium point B with the gap closed but with a higher price level ( P 1 > P 0 ). However, if people buy now before the price level rises to P 1 the first thing that happens is that AD will increase from AD 0 to AD 1 . This makes the inflationary gap worse! The economy goes from equilibrium point A to point C and the inflationary gap grows from ( Y 1 Y 0 ) to ( Y 2 Y 0 ), with higher price level ( P 2 ). This means that there are even greater pressures on firms than before so wages and costs will be driven even higher resulting in a shift up of SAS not to SAS 1 but rather to SAS 2 . Thus we go from point C up to point D. At point D the inflationary gap is closed since real output is at the potential output level of Y 0 . However the price level is much higher than it was when we started ( P 3 > P 0 ). Colander's Macroeconomics 140
Chapter 10: The Aggregate Demand-Aggregate Supply Model 39. 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.

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