Question

Inflation started to creep up in the late 1960's. By 1968, inflation was about 4% and by 1973, inflation was about 6%. By 1980, inflation was at 13.5%. The Fed, led by Chairman Paul Volcker, engineered a recession that eventually disinflated the economy fluctuations models, explain how the Fed disinflates the economy from 13.5% to 3.5%, and what the effects of that disinflation are in the SR and the LR. Also explain the model and the shifts in words.

Answer 1

Fed can disinflate the economy by decreasing money supply, which will increase interest rate, lowering investment demand and reducing aggregate demand. AD curve will shift to left, reducing both price level and real GDP, giving rise to a recessionary gap in short run.

In the long run, lower price level will decrease wages and production costs. Firms will increase output, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real GDP to potential GDP level, wiping out the short-run recessionary gap.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (= potential GDP) Y0. When aggregate demand falls, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap of (Y0 - Y1). In the long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0, removing the short-run recessionary gap.