Nation Long Runeconomic Growth Case Questions

Description

3 attachmentsSlide 1 of 3attachment_1attachment_1attachment_2attachment_2attachment_3attachment_3.slider-slide > img { width: 100%; display: block; }
.slider-slide > img:focus { margin: auto; }

Unformatted Attachment Preview

???????? ??????? ?????????
?????? ????????
???????? ???????? ????????????
Kingdom of Saudi Arabia
Ministry of Education
Saudi Electronic University
College of Administrative and Financial Sciences
Assignment 3
Macroeconomics (ECON201)
Due Date:30th April2022 @ 23:59
Course Name:Macroeconomics
Student’s Name:
Course Code:ECON201
Student’s I.D. Number:
Semester: II
CRN:
Academic Year:2021-22-2nd
For Instructor’s Use only
Instructor’s Name:
Students’ Grade: 00/10
Level of Marks: High/Middle/Low
General Instructions – PLEASE READ THEM CAREFULLY
•
•
•
•
•
•
•
•
The Assignment must be submitted on Blackboard (WORD format only) via
allocated folder.
Assignments submitted through email will not be accepted.
Students are advised to make their work clear and well presented, marks may be
reduced for poor presentation. This includes filling your information on the cover
page.
Students must mention question number clearly in their answer.
Late submission will NOT be accepted.
Avoid plagiarism, the work should be in your own words, copying from students
or other resources without proper referencing will result in ZERO marks. No
exceptions.
All answered must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered
plagiarism).
Submissions without this cover page will NOT be accepted.
Chapter 17 & 20: Case Study:Money Growth and Inflation and Aggregate Demand and
Aggregate Supply: (10 Points)
In the third assignment for the Macroeconomics course, the students are required to discuss how changes
in the quantity of money affect the economy and the aggregate demand and the aggregate supply
explains the economic fluctuations. Answer the questions given, upon successful completion of the
assignment; the student should be able to achieve the following learning outcomes:
Learning Outcomes:
1. Describe how to evaluate macroeconomic conditions such as unemployment, inflation, and
growth. [CLO 1.2]
2. Recognize the fundamental determinant’s of a nation’s long-runeconomic growth. [CLO 1.3]
Reference Source:
Textbook: -“-“Mankiw, N. Gregory. Principles of Macroeconomics, 6th ed. Mason, OH: South-
Western Cengage Learning, 2011. ISBN: 9780538453066 (hard copy); ISBN: 9781115468523
(eBook)”
. Mason, OH: South-Western Cengage Learning, 2011. ISBN: 9780538453066 (hard copy); ISBN:
9781115468523 (eBook)”
Case Study:1(5 Points)
Please read the case “Money and Prices during Four Hyperinflations” from Chapter 17 “Money
Growth and Inflation” Page: – 652-Chapter 30given in your textbook –“Principles of
Macroeconomics”.The case study presented in the chapter discussed the government can pay for some
of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result
is hyperinflation. and Answer the following Questions:
Questions:
1.1.Suppose a country’s inflation rate increases sharply. What happens to the inflation tax on the
holders of the money? Why is wealth that is held in savings accounts not subject to a change in
the inflation tax? Can you think of any way holders of savings accounts are hurt by the increase
in the inflation rate? (2.5 points)
1.2.It is sometimes suggested that the Federal Reserve should try to achieve zero inflation. If we
assume that velocity is constant, does this zero-inflation goal require that the rate of money
growth equal zero? If yes, explain why? If no, explain what the rate of money growth should
equal? (2.5 points)
Important Note: – Support your submission with course material concepts, principles, and
theories from the textbook and at least two scholarly, peer-reviewed journal articles.
Case Study:2(5 Points)
Please read the case “Oil and the Economy” from Chapter 20 “Aggregate Demand and Aggregate
Supply” Page: – 750– Chapter 33given in your textbook –“Principles of Macroeconomics”.A case
study discusses the model of aggregate demand and aggregate supply explains the economic
fluctuations.
Questions:
2.1.Explain the short-run and long-run impacts of oil price increase on output and price level in the
U.S. during 1973-1975 periods using the model of aggregate demand and aggregate supply.(2.5
points)
2.2.Explain the short-run and long-run impacts of oil price fall on output and price level in the U.S.
in 1986, using the model of aggregate demand and aggregate supply (2.5 points)
Important Note: – Support your submission with course material concepts, principles, and
theories from the textbook and at least two scholarly, peer-reviewed journal articles.
Answer:
CASE STUDY 1
1.1
•
According to the course materials, it was explicitly stated that the inflation tax is not exactly like
other taxes! However, because no one receives a bill from the government for this tax. Instead,
the inflation tax was subtler, meaning it is of little or no effect on the holder of money; thus, their
attention is not drawn to an inflation tax because it’s more or less implicit.
•
Wealth in a savings account is not subject to a change in inflation tax. In simple words, when
you save, you are expected to have some interest on your savings right, which is the nominal
interest rate; assuming inflation set in now to a savings account, it will only cut down on your
nominal interest, which gives you the real rate, this can mean neutrality at the end of the day
because this sums up as the Fischer effect.
•
Yes, one of the ways they are hurt is, in the long run, there is a runaway/hyperinflation; this eats
deep into their interest and the real interest itself, bringing unaccounted loss and the ability to
purchase goods and services declines. Their purchasing power has now been affected and what
they could get at a lower price now seems very high.
•
Another effect it has on savings Evan 2021, reviewed by Robert c kelly, is that it diminishes the
worth of a dollar over the long haul. The time worth of cash is an idea that portrays how the cash
is accessible to you today and how it is worth more in the near future.
•
This implies that you don’t put away the cash accessible to you in value security. Basically,
assuming you have a dollar in your pocket today, that dollar’s worth, or worth, will be lower one
year from today when you keep it in your pocket. Assuming wages continue as before yet
inflation makes the costs of labor and products increment over the long run,
1.2
NO, because the issue of inflation is that the government kept on printing more money into the economy
regardless of the underlying effects of their actions. Joined with the fact there’s no gold backing to fiat
currency, i.e., paper-printed money, I would suggest that the growth of money should be less than that of
inflation; less money should be pumped in to stabilize the economy, not imbibing a zero inflation
society. Just like the popular theory of “the higher the supply the lower the demand and vice versa,” the
government should checklist that theory and understand that inflation demand raises as a result of an
increase in money pumping or supply into an economy.
CASE STUDY 2
2.1
•
1973, in the short run, the oil price was short in output which increased the prices level of Oil;
the higher the price, the lower the demand, and vice versa; it was said that the price doubled, as
the countries with the largest oil reserves were united as OPEC to create competition.
•
In the long run, Oil was a major deciding factor in economic growth and unemployment rose;
shifts in aggregate supply can cause stagflation, which is both in fall and rise. Policy influencers,
which can make aggregate demand, can potentially control the adverse effect on output, but only
at the cost of increasing inflation, which is the main problem.
•
1987, in the short run, oil prices fell by about half and the output was low. This fall in oil prices
was able to bring down costs to U.S. firms; this brought about a lower price to now make fuels
available to its society. Therefore, the aggregate-supply curve was said to have shifted to the
right.
2.2.
•
In the long run, the U.S. economy had inflation reached its lowest rate. Aggregate-supply curve
shifts to the right. This was all due to a disagreement among members of OPEC. While some
countries rebelled on their initial agreement, which yielded another economic growth for the U.S.
•
Inflation eventually doubles the cost of labor and services after some time, really diminishing the
quantity of labor and products you can purchase with a dollar in the future rather than a dollar
today. However, the Ethiopian economy was known for its low inflation on her savings in history
all around 2003 happenings.
•
In a general overview of both cases, the economy’s capacity to deliver yield, like changes in
labor, capital, regular assets, or innovation, shifts the short-run total supply curve (and may move
the long-run total supply curve too). Moreover, the place of the short-run total supply curve
relies upon the normal cost level. One potential reason for monetary variances is a change in
total interest. When the aggregate demand curve moves to one side, for example, results and
costs fall in the short run. Over time, as an adjustment of the normal cost-level causes wages,
costs, and insights to change, the short-run total supply curve moves to the right. This shift
returns the economy to its normal pace of result, lower-cost level and a mix later called
stagflation.
652
PART X
Money and Prices in the Long Run
We now have all the elements necessary to explain the equilibrium price level
and inflation rate. Here they are:
1. The velocity of money is relatively stable over time.
2. Because velocity is stable, when the central bank changes the quantity of
money (M), it causes proportionate changes in the nominal value of output
(P × Y).
3. The economy’s output of goods and services (Y) is primarily determined
by factor supplies (labor, physical capital, human capital, and natural
resources) and the available production technology. In particular, because
money is neutral, money does not affect output.
4. With output (Y) determined by factor supplies and technology, when the
central bank alters the money supply (M) and induces proportional changes
in the nominal value of output (P × Y), these changes are reflected in
changes in the price level (P).
5. Therefore, when the central bank increases the money supply rapidly, the
result is a high rate of inflation.
These five steps are the essence of the quantity theory of money.
Money and Prices during Four Hyperinflations
Although earthquakes can wreak havoc on a society, they have the beneficial
by-product of providing much useful data for seismologists. These data can shed
light on alternative theories and, thereby, help society predict and deal with
future threats. Similarly, hyperinflations offer monetary economists a natural
experiment they can use to study the effects of money on the economy.
Hyperinflations are interesting in part because the changes in the money
supply and price level are so large. Indeed, hyperinflation is generally defined
as inflation that exceeds 50 percent per month. This means that the price level
increases more than a hundredfold over the course of a year.
The data on hyperinflation show a clear link between the quantity of money
and the price level. Figure 4 graphs data from four classic hyperinflations that
occurred during the 1920s in Austria, Hungary, Germany, and Poland. Each
graph shows the quantity of money in the economy and an index of the price
level. The slope of the money line represents the rate at which the quantity of
money was growing, and the slope of the price line represents the inflation rate.
The steeper the lines, the higher the rates of money growth or inflation.
Notice that in each graph the quantity of money and the price level are almost
parallel. In each instance, growth in the quantity of money is moderate at first and
so is inflation. But over time, the quantity of money in the economy starts growing faster and faster. At about the same time, inflation also takes off. Then when
the quantity of money stabilizes, the price level stabilizes as well. These episodes
illustrate well one of the Ten Principles of Economics: Prices rise when the government prints too much money. ?
The Inflation Tax
If inflation is so easy to explain, why do countries experience hyperinflation? That
is, why do the central banks of these countries choose to print so much money that
its value is certain to fall rapidly over time?
Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CHAPTER 30
Money Growth and Inflation
This figure shows the quantity of money and the price level during four
hyperinflations. (Note that these variables are graphed on logarithmic scales. This
means that equal vertical distances on the graph represent equal percentage changes
in the variable.) In each case, the quantity of money and the price level move closely
together. The strong association between these two variables is consistent with
the quantity theory of money, which states that growth in the money supply is the
primary cause of inflation.
Figure
Money and Prices
during Four
Hyperinflations
Source: Adapted from Thomas J. Sargent, “The End of Four Big Inflations,” in Robert Hall, ed., Inflation (Chicago: University of
Chicago Press, 1983), pp. 41–93.
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
1924
1925
(d) Poland
(c) Germany
Index
(Jan. 1921 = 100)
Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1
1923
10,000,000
Price level
Price level
1,000,000
Money
supply
Money
supply
100,000
10,000
1,000
1921
1922
1923
1924
1925
100
1921
The answer is that the governments of these countries are using money creation
as a way to pay for their spending. When the government wants to build roads,
pay salaries to its soldiers, or give transfer payments to the poor or elderly, it first
has to raise the necessary funds. Normally, the government does this by levying
taxes, such as income and sales taxes, and by borrowing from the public by selling government bonds. Yet the government can also pay for spending simply by
printing the money it needs.
When the government raises revenue by printing money, it is said to levy an
inflation tax. The inflation tax is not exactly like other taxes, however, because no
one receives a bill from the government for this tax. Instead, the inflation tax is
subtler. When the government prints money, the price level rises, and the dollars
in your wallet are less valuable. Thus, the inflation tax is like a tax on everyone who
holds money.
The importance of the inflation tax varies from country to country and over
time. In the United States in recent years, the inflation tax has been a trivial
1922
1923
1924
1925
inflation tax
the revenue the
government raises by
creating money
Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
653
4
654
PART X
Money and Prices in the Long Run
source of revenue: It has accounted for less than 3 percent of government reve­
nue. During the 1770s, however, the Continental Congress of the fledgling
United States relied heavily on the inflation tax to pay for military spending.
Because the new government had a limited ability to raise funds through regular
taxes or borrowing, printing dollars was the easiest way to pay the American
soldiers. As the quantity theory predicts, the result was a high rate of inflation:
Prices measured in terms of the continental dollar rose more than a hundredfold
over a few years.
Almost all hyperinflations follow the same pattern as the hyperinflation during the American Revolution. The government has high spending, inadequate
tax revenue, and limited ability to borrow. As a result, it turns to the printing
press to pay for its spending. The massive increases in the quantity of money lead
to massive inflation. The inflation ends when the government institutes fiscal
reforms—such as cuts in government spending—that eliminate the need for the
inflation tax.
FYI
Hyperinflation in Zimbabwe
© Eugene Baron
D
uring the decade of the 2000s, the nation of Zimbabwe
experienced one of history’s most extreme examples of hyperinflation. In many ways, the story is common: Large government
budget deficits led to the creation of large quantities of money
and high rates of inflation. The hyperinflation ended in April 2009
when the Zimbabwe central bank stopped printing the Zimbabwe
dollar, and the nation started using foreign currencies such as the
U.S. dollar and the South African rand as the medium of exchange.
Estimates vary about how high inflation in Zimbabwe got, but
the magnitude of the problem is well documented by the denomination of the notes being issued by the central bank. Before the
hyperinflation started, the Zimbabwe dollar was worth a bit more
than one U.S. dollar, so the denominations of the paper currency
were similar to those one would find in the United States. A
person might carry, for example, a ten-dollar note in his or her
wallet. In January 2008, however, after years of high inflation,
the Reserve Bank of Zimbabwe issued a note worth 10 million
Zimbabwe dollars, which was then equivalent to about four U.S.
dollars. But even that did not prove to be large enough. A year
later, the central bank announced it would issue notes worth 10
trillion Zimbabwe dollars, then worth about three U.S. dollars.
As prices rose and the central bank printed ever larger denominations of money, the older, smaller denomination currency lost
value and became almost worthless. One indication of this phenomenon can be found on this sign from a public restroom in
Zimbabwe:
Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CHAPTER 30
Money Growth and Inflation
The Fisher Effect
According to the principle of monetary neutrality, an increase in the rate of money
growth raises the rate of inflation but does not affect any real variable. An important application of this principle concerns the effect of money on interest rates.
Interest rates are important variables for macroeconomists to understand because
they link the economy of the present and the economy of the future through their
effects on saving and investment.
To understand the relationship between money, inflation, and interest rates,
recall the distinction between the nominal interest rate and the real interest rate.
The nominal interest rate is the interest rate you hear about at your bank. If you
have a savings account, for instance, the nominal interest rate tells you how fast
the number of dollars in your account will rise over time. The real interest rate
corrects the nominal interest rate for the effect of inflation to tell you how fast the
purchasing power of your savings account will rise over time. The real interest
rate is the nominal interest rate minus the inflation rate:
Real interest rate = Nominal interest rate 2 Inflation rate.
For example, if the bank posts a nominal interest rate of 7 percent per year and
the inflation rate is 3 percent per year, then the real value of the deposits grows
by 4 percent per year.
We can rewrite this equation to show that the nominal interest rate is the sum
of the real interest rate and the inflation rate:
Nominal interest rate = Real interest rate 1 Inflation rate.
This way of looking at the nominal interest rate is useful because different economic forces determine each of the two terms on the right side of this equation.
As we discussed earlier in the book, the supply and demand for loanable funds
determine the real interest rate. And according to the quantity theory of money,
growth in the money supply determines the inflation rate.
Let’s now consider how the growth in the money supply affects interest rates.
In the long run over which money is neutral, a change in money growth should
not affect the real interest rate. The real interest rate is, after all, a real variable.
For the real interest rate not to be affected, the nominal interest rate must adjust
one-for-one to changes in the inflation rate. Thus, when the Fed increases the rate of
money growth, the long-run result is both a higher inflation rate and a higher nominal interest
rate. This adjustment of the nominal interest rate to the inflation rate is called the
Fisher effect, after economist Irving Fisher (1867–1947), who first studied it.
Keep in mind that our analysis of the Fisher effect has maintained a long-run
perspective. The Fisher effect need not hold in the short run because inflation
may be unanticipated. A nominal interest rate is a payment on a loan, and it is
typically set when the loan is first made. If a jump in inflation catches the borrower and lender by surprise, the nominal interest rate they agreed on will fail to
reflect the higher inflation. But if inflation remains high, people will eventually
come to expect it, and loan agreements will reflect this expectation. To be precise,
therefore, the Fisher effect states that the nominal interest rate adjusts to expected
inflation. Expected inflation moves with actual inflation in the long run, but that
is not necessarily true in the short run.
The Fisher effect is crucial for understanding changes over time in the nominal
interest rate. Figure 5 shows the nominal interest rate and the inflation rate in the U.S.
economy since 1960. The close association between these two variables is clear. The
nominal interest rate rose from the early 1960s through the 1970s because inflation
Fisher effect
the one-for-one
adjustment of the
nominal interest rate to
the inflation rate
Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
655
656
PART X
Figure
Money and Prices in the Long Run
5
The Nominal Interest Rate
and the Inflation Rate
This figure uses annual data since 1960 to show the nominal interest rate on threemonth Treasury bills and the inflation rate as measured by the consumer price index.
The close association between these two variables is evidence for the Fisher effect:
When the inflation rate rises, so does the nominal interest rate.
Source: U.S. Department of Treasury; U.S. Department of Labor.
Percent
(per year)
15
12
Nominal interest rate
9
6
Inflation
3
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
–3
was also rising during this time. Similarly, the nominal interest rate fell from the early
1980s through the 1990s because the Fed got inflation under control.
Quick Quiz The government of a country increases the growth rate of the money
supply from 5 percent per year to 50 percent per year. What happens to prices? What
happens to nominal interest rates? Why might the government be doing this?
The Costs of Inflation
In the late 1970s, when the U.S. inflation rate reached about 10 percent per year,
inflation dominated debates over economic policy. And even though inflation has
been low over the past decade, it remains a closely watched macroeconomic variable. One study found that inflation is the economic term mentioned most often in
U.S. newspapers (far ahead of second-place finisher unemployment and third-place
finisher productivity).
Inflation is closely watched and widely discussed because it is thought to be a
serious economic problem. But is that true? And if so, why?
A Fall in Purchasing Power? The Inflation Fallacy
If you ask the typical person why inflation is bad, he will tell you that the answer
is obvious: Inflation robs him of the purchasing power of his hard-earned dollars.
Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CHAPTER 30
Money Growth and Inflation
When prices rise, each dollar of income buys fewer goods and services. Thus, it
might seem that inflation directly lowers living standards.
Yet further thought reveals a fallacy in this answer. When prices rise, buyers of
goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn
their incomes by selling their services, such as their labor, inflation in incomes
goes hand in hand with inflation in prices. Thus, inflation does not in itself reduce
people’s real purchasing power.
People believe the inflation fallacy because they do not appreciate the principle
of monetary neutrality. A worker who receives an annual raise of 10 percent tends
to view that raise as a reward for her own talent and effort. When an inflation rate
of 6 percent reduces the real value of that raise to only 4 percent, the worker might
feel that she has been cheated of what is rightfully her due. In fact, as we discussed
in the chapter on production and growth, real incomes are determined by real variables, such as physical capital, human capital, natural resources, and the available
production technology. Nominal incomes are determined by those factors and the
overall price level. If the Fed were to lower the inflation rate from 6 percent to zero,
our worker’s annual raise would fall from 10 percent to 4 percent. She might feel
less robbed by inflation, but her real income would not rise more quickly.
If nominal incomes tend to keep pace with rising prices, why then is inflation
a problem? It turns out that there is no single answer to this question. Instead,
economists have identified several costs of inflation. Each of these costs shows
some way in which persistent growth in the money supply does, in fact, have
some effect on real variables.
Shoeleather Costs
As we have discussed, inflation is like a tax on the holders of money. The tax
itself is not a cost to society: It is only a transfer of resources from households to
the government. Yet most taxes give people an incentive to alter their behavior to
avoid paying the tax, and this distortion of incentives causes deadweight losses
for society as a whole. Like other taxes, the inflation tax also causes deadweight
losses because people waste scarce resources trying to avoid it.
How can a person avoid paying the inflation tax? Because inflation erodes the
real value of the money in your wallet, you can avoid the inflation tax by holding less money. One way to do this is to go to the bank more often. For example,
rather than withdrawing $200 every four weeks, you might withdraw $50 once
a week. By making more frequent trips to the bank, you can keep more of your
wealth in your interest-bearing savings account and less in your wallet, where
inflation erodes its value.
The cost of reducing your money holdings is called the shoeleather cost of
inflation because making more frequent trips to the bank causes your shoes to
wear out more quickly. Of course, this term is not to be taken literally: The actual
cost of reducing your money holdings is not the wear and tear on your shoes but
the time and convenience you must sacrifice to keep less money on hand than you
would if there were no inflation.
The shoeleather costs of inflation may seem trivial. And in fact, they are in the
U.S. economy, which has had only moderate inflation in recent years. But this cost
is magnified in countries experiencing hyperinflation. Here is a description of one
person’s experience in Bolivia during its hyperinflation (as reported in the August
13, 1985, issue of The Wall Street Journal):
shoeleather costs
the resources wasted
when inflation encourages
people to reduce their
money holdings
Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
657
750
PART Xii
Figure
Short-Run Economic Fluctuations
11
Accommodating an Adverse
Shift in Aggregate Supply
Faced with an adverse shift
in aggregate supply from AS1
to AS2, policymakers who can
influence aggregate demand
might try to shift the aggregatedemand curve to the right from
AD1 to AD2. The economy would
move from point A to point
C. This policy would prevent
the supply shift from reducing
output in the short run, but the
price level would permanently
rise from P1 to P3.
1. When short-run aggregate
supply falls . . .
Price
Level
Long-run
aggregate
supply
P3
C
P2
3. . . . which P1
causes the
price level
to rise
further . . .
A
4. . . . but keeps output
at its natural rate.
0
Natural rate
of output
Short-run
aggregate
supply, AS1
AS2
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
AD2
Aggregate demand, AD1
Quantity of
Output
the long run, the economy returns to point A, where the aggregate-demand curve
crosses the long-run aggregate-supply curve.
This transition back to the initial equilibrium assumes, however, that aggregate
demand is held constant throughout the process. In the real world, that may not be
the case. Policymakers who control monetary and fiscal policy might attempt to offset some of the effects of the shift in the short-run aggregate-supply curve by shifting the aggregate-demand curve. This possibility is shown in Figure 11. In this case,
changes in policy shift the aggregate-demand curve to the right from AD1 to AD2—
exactly enough to prevent the shift in aggregate supply from affecting output. The
economy moves directly from point A to point C. Output remains at its natural rate,
and the price level rises from P1 to P3. In this case, policymakers are said to accommodate the shift in aggregate supply. An accommodative policy accepts a permanently
higher level of prices to maintain a higher level of output and employment.
To sum up, this story about shifts in aggregate supply has two important lessons:
• Shifts in aggregate supply can cause stagflation—a combination of recession
(falling output) and inflation (rising prices).
• Policymakers who can influence aggregate demand can potentially mitigate
the adverse impact on output but only at the cost of exacerbating the problem
of inflation.
Oil and the Economy
Some of the largest economic fluctuations in the U.S. economy since 1970 have
originated in the oil fields of the Middle East. Crude oil is a key input into the
production of many goods and services, and much of the world’s oil comes from
Saudi Arabia, Kuwait, and other Middle Eastern count