Dimitri Wilson

MBA 6130 Homework 5 – Week 7

Dr. Said
Question #1: Suppose the Fed has observed the economy is experiencing Demand-Pull inflation
and a positive output gap. Discuss the monetary policy process and tools that can be used to
address an inflationary output gap. Depict graphically the impact of these policy actions in the
AD-AS model. What happens to the equilibrium price level and output level?
Since the economy is experiencing Demand-Pull inflation and a positive output gap then there is
an inflationary gap. Note that an inflationary gap occurs when the real GDP in the current
equilibrium is greater than its potential level. In this case, the combination of the average price
level and real GDP lies to the right of their long-run combination in the long-term.
If the Fed is willing to close the positive output gap, it should use the policy of monetary
contraction, where it can increase the reserve requirements, discount rate, or sell government
securities. Banks hold a proportion of deposits as required reserves which impede their ability to
extend loans. Higher reserve requirements imply reduced excess reserves, and this indicates
fewer loans being produced. When there are fewer loans, the supply of real money balances will
fall and in the money market, this would push the interest rate up. With a higher rate of interest,
investment spending, and consumer spending fall and this reduces the aggregate demand. Then,
the AD curve would shift to the left which would restore the original long-run equilibrium. This
implies that the price level and level of real GDP will fall because of monetary contraction and
the positive output gap is closed.

Question #3: If in 2016 GDP was $18 trillion and the CPI was 240. Suppose that in 2017 the US
has continued the previous trend of economic growth such that unemployment is approximately
3%, inflation is approximately 5%, and the current output and output price level are $19.5 trillion
and 260 respectively. How would you describe this circumstance? Depict this outcome
graphically in the AS-AD model.
Nominal value of GDP in 2017 (in terms of 2016 dollars) = 19.5*(240/260)
Nominal value of GDP in 2017 (in terms of 2016 dollars) = $18 Trillion
Inflation rate as per the CPI = (260-240)/240 = 8.33% (The actual inflation rate in 2017 is 5%)
Although inflation has caused an increase in the nominal value of GDP, real GDP does not
change.
As shown below, AD shifts to the right in 2017 with lower unemployment rate. This creates
demand pull inflation, so AS shifts to the left in 2017. In conclusion, real GDP remains the
same but price increases.

-What forms could Fiscal Policy take to address this circumstance?

Suppose the government decided to increase taxes to rein in consumer spending, but everything
else in the economy remained the same. On the graph about this would shift the aggregate
demand curve (AD), the short-run aggregate supply curve (AS), or both to show the intended
short-run effect of this fiscal policy on the economy. Such a change would look similar to the
change in aggregate demand and aggregate supply between 2016 and 2017 in the graph shown
above.