MBA502, Economics for Business
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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.
1. A surprise increase in investment spending
In the short run, when investment spending increases, it results in an increase in Aggregate Demand (AD), which in turn pushes up both GPD and the price index.
To counterbalance this development, government might pursue contractionary fiscal policy by increasing taxes (to reduce consumption) or decreasing its own investment and spending so that the AD curve shifts back to its original position. Alternatively, the government can pursue contractionary monetary policy by reducing money supply and increasing interest rate to discourage economic activity.
2. Catastrophic floods that cause a sharp food price increase
In this case, sharp food shortages and consequent price increases cause a shock-type adjustment of the aggregate supply curve (it shift up and to the left). The result is a lower GDP and a higher price level.
The government cannot do anything to adjust AS in the short run. However, if the goal is to maintain the price level constant, the government can decide to do something to decrease the aggregate demand to force prices to come down, though it will be accompanies by another contraction in GDP and so it would not be a smart thing to do.
To cause AD to decrease, the government, similar to example above, can pursue fiscal policy (increase taxes, decrease spending) or monetary policy (reduce supply of money to the economy and thus increase interest rates).
3. A productivity decline that reduces potential output
In this case, AS shifts to the left, as was the case in example 2. As a result, price levels go up, as the same amount of money is chasing the reduced amount of goods and services, and GDP declines.
Government remedies here would be centered about causing AD to decrease through contractionary fiscal (higher taxes, lower spending) or monetary (reduce money supply and increase interest rates) policy. Again, this decision reduces inflation but at expense of GDP, as real output shrinks further.
4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States
A decrease in exports of goods to from the United States to Asia will mean that the aggregate demand (which includes net exports
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