Suppose the potential output g
Suppose the potential output growth of a country is actually 3percent but policymakers erroneously believe that it is 5 percentand try to stimulate the economy persistently to achieve 5 percentgrowth. How would inflation and output move over time? Explainusing the AD-AS and LRAS framework.
Answer:
To achieve the 5% of growthrate, policy makers would adopt expansionary monetary policy inwhich they would increase the money supply in the economy by buyingbonds. Suppose the economy is in equilibrium at point E where ADcurve, AS curve and LRAS all intersects.Initial price level is Pand potential output is shown by Yn. See the figure above.
In the short run, as money supply increases, AD curve shifts tothe right. The new equilibrium is E’ where both AD’ curve and AScurve intersects.Both output and prices rises to Y’ and P’respectively. But this cannot be equilibrium for long term becausemaximum potential output is Yn and Y’exceeds Yn. So over time, theadjustment of price expectations comes into play. As output ishigher than the potential level of output, the price level ishigher than wage setters expected. So they revise theirexpectations, which causes AS curve to shift upward over time. Theeconomy moves up along the along the AD’ curve. The adjustmentprocess stops when output has returned to the potential level ofoutput i.e Yn. Therefore in the long run AS curve shifts to AS” andequilibrium is found to be at A”.At this equilibrium output is backto Yn and price level rise to P”.
In such a scenario of targetting more than the potential growtheconomy could witness high inflation and obviously no changes inoutput.
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