Source: Principles of Macroeconomics, Case/Fair, 8e
Difficulty: Intermediate to Advanced Prerequisites: Parts 1 and 2 of these notes (AD curve, AS curve, equilibrium price level, potential output).
Tags: fiscal policy, monetary policy, demand-pull inflation, cost-push inflation, stagflation, inflationary gap, recessionary gap, expansionary policy, contractionary policy, hyperinflation, simple Keynesian view, policy effectiveness, AD/AS model
This section brings everything together: how monetary and fiscal policy interact with the AD/AS model, what happens when the economy is above or below potential output, and where inflation comes from. Understanding the distinction between demand-pull and cost-push inflation, and why sustained inflation requires monetary accommodation, is essential for the rest of the macroeconomics course. This is also where you meet the policy dilemma that governments face when a supply shock hits.
Expansionary policies (more spending, lower taxes, more money) shift AD right and work well when the economy has spare capacity, but mostly just raise prices when the economy is at or near capacity. Inflation can be demand-pull (AD shifts right) or cost-push (AS shifts left). Sustained inflation requires the Fed to keep expanding the money supply. Supply shocks create the worst policy dilemma: rising prices and falling output at the same time.
Expansionary policy
Government actions that increase aggregate demand or aggregate supply. Examples: increasing government spending, decreasing net taxes, increasing the money supply. In simple terms, policies designed to boost the economy.
Contractionary policy
Government actions that decrease aggregate demand or aggregate supply. Examples: decreasing government spending, increasing net taxes, decreasing the money supply. These are used to cool an overheating economy.
Demand-pull inflation
Inflation caused by a rightward shift in the aggregate demand curve. Too much spending chases too few goods, pulling prices up. Think of it as "too much money chasing too few goods."
Cost-push inflation
Inflation caused by a leftward shift in the aggregate supply curve, typically from a rise in input costs (oil, raw materials, wages). Prices are pushed up from the supply side, and output falls at the same time.
Stagflation
The combination of falling output and rising prices. This occurs when the AS curve shifts to the left. It is the worst-case scenario for policymakers because the usual tools to fight inflation (contractionary policy) would make the output decline worse, and tools to fight the recession (expansionary policy) would make the inflation worse.
Inflationary gap
The situation where planned aggregate expenditure exceeds capacity output (potential GDP). The economy is trying to produce more than it sustainably can, generating upward pressure on prices.
Recessionary gap
The situation where planned aggregate expenditure is less than potential output. The economy is underperforming, with unemployment above the natural rate.
Hyperinflation
Extremely rapid inflation, often exceeding hundreds or thousands of percent per year. Examples: Bosnia in 1993 (prices rising 1% per hour), Argentina in the early 1980s (roughly 2,000% per year).
Monetary accommodation
When the Federal Reserve expands the money supply to support or sustain an ongoing inflation, often to keep interest rates from rising as the government increases spending. Economists generally agree that sustained inflation cannot persist without monetary accommodation.
Crowding out
When government spending displaces private investment. Complete crowding out occurs when the economy is at full capacity: the government spends more, but total output cannot increase, so investment falls by the full amount of the spending increase.
Where the economy sits on the AS curve determines whether policy changes mostly affect output or prices:
Economy on the flat part of AS (well below capacity): Expansionary policy increases output with little or no increase in the price level. This is the ideal scenario for stimulus.
Economy on the steep part of AS (near capacity): Expansionary policy mostly increases the price level with only a small increase in output.
Economy at capacity (vertical AS): Expansionary policy has zero effect on output and only raises the price level. The multiplier effect on output in the long run is zero.
In the simplified Keynesian model, the AS curve is horizontal up to full capacity and then becomes vertical:
Below full capacity, expansionary policy increases output but not the price level.
At full capacity, expansionary policy increases the price level but not output.
This is a useful simplification for understanding the basic trade-off, though real economies have a more gradually sloping AS curve.
When the economy is at potential output and the government enacts expansionary policy (e.g. increases spending):
Short run: AD shifts right. Output rises above potential, and the price level increases. The economy moves to a point above and to the right of the LRAS.
Long run: Because the economy is above potential, input prices (wages, materials) begin rising. The short-run AS curve shifts left. Output falls back to potential, but the price level is now permanently higher.
When the economy is below potential (e.g. in a recession):
Input prices are likely to fall over time.
The AS curve gradually shifts right, moving the economy back toward potential output.
Alternatively, expansionary policy can speed the recovery by shifting AD right.
Demand-pull inflation:
Caused by a rightward shift in AD
Both output and the price level increase in the short run
Typical causes: increased government spending, tax cuts, monetary expansion
Cost-push inflation:
Caused by a leftward shift in AS
The price level increases while output falls (stagflation)
Typical causes: oil price increases, natural disasters, wage increases from strikes, inflationary expectations that cause firms to raise prices
When a supply shock (e.g. an oil embargo) shifts AS left, policymakers face a lose-lose choice:
Do nothing: Prices rise and output falls. Eventually, input prices may adjust downward and AS shifts back, but this can take a long time.
Expansionary policy (fight the recession): Output recovers, but the price level rises even further above where the supply shock pushed it.
Contractionary policy (fight the inflation): The price level falls, but output drops even further.
A one-off shift in AD or AS can cause a temporary increase in the price level, but for inflation to be sustained (continuing to rise period after period), the Federal Reserve must accommodate it by continuing to increase the money supply.
If the government increases spending, money demand rises and the interest rate would normally increase, which would partially offset the stimulus.
For the Fed to keep the interest rate unchanged while spending rises, it must keep increasing the money supply.
Most economists agree: without ongoing monetary expansion, inflation is self-limiting.
When firms expect prices to rise in the future, they raise their own prices now. This shifts the AS curve to the left, which itself causes prices to rise, potentially confirming the expectations and creating a self-reinforcing cycle.
Increased inflationary expectations → AS shifts left → prices rise, output falls.
Decreased inflationary expectations → AS shifts right → prices fall, output rises.
Some exam questions test whether you can predict the unambiguous direction of change when two policies act simultaneously:
Decrease in income tax (AD shifts right) + increase in corporate profit tax (AS shifts left) → price level unambiguously rises. Output effect is ambiguous.
Decrease in wages (AS shifts right) + increase in government spending (AD shifts right) → output unambiguously rises. Price-level effect is ambiguous.
Increase in government spending (AD shifts right) + decrease in raw material prices (AS shifts right) → output unambiguously rises. Price-level effect is ambiguous.
Demand-pull inflation chain:
G↑ or Ms↑ → AD shifts right → P↑ and Y↑ (short run)
Cost-push inflation chain:
Input costs↑ → AS shifts left → P↑ and Y↓ (stagflation)
Long-run adjustment when economy exceeds potential:
Y > Y* → wages and input costs rise → AS shifts left → Y returns to Y*, P is higher
Long-run adjustment when economy is below potential:
Y < Y* → wages and input costs fall → AS shifts right → Y returns to Y*, P is lower
The oil crises of 1973 and 1979 are textbook examples of cost-push inflation and stagflation. Oil prices spiked, shifting AS left, and Western economies experienced simultaneous recession and inflation. Policymakers struggled because fighting one problem worsened the other.
Hyperinflation episodes in Zimbabwe (2000s) and Venezuela (2010s) illustrate what happens when a central bank continuously expands the money supply to finance government spending. The sustained monetary accommodation turns a one-off price increase into an accelerating spiral.
Students often think an earthquake or oil embargo is a "contractionary policy." These are supply shocks, not policies. Contractionary policies are deliberate government or central bank actions (raising taxes, cutting spending, reducing money supply).
Students sometimes believe that if the economy is on the flat part of the AS curve, expansionary policy will mostly increase the price level. The opposite is true: on the flat part, output rises with little price increase.
A frequent error is thinking that raising net taxes and an oil embargo will both increase the price level. Raising net taxes shifts AD left, which lowers the price level. An oil embargo shifts AS left, which raises it. They push prices in opposite directions.
Students confuse "inflation" with "a one-time increase in the price level." Inflation is a sustained increase. A single AD shift causes a one-time price rise, not ongoing inflation, unless the Fed continuously expands the money supply.
⚠️ Know the difference between demand-pull and cost-push inflation, and which curve shifts in each case (AD for demand-pull, AS for cost-push).
⚠️ Stagflation = AS shifts left. For the economy to experience both recession and inflation simultaneously, the aggregate supply curve must shift to the left.
⚠️ If the long-run AS curve is vertical, the multiplier effect of fiscal and monetary policy on output is zero in the long run. Policy only affects the price level.
⚠️ Complete crowding out of investment happens when the economy is operating at capacity.
⚠️ Sustained inflation requires monetary accommodation (the Fed expanding the money supply). This is a core exam concept.
⚠️ An earthquake or oil embargo is a supply shock, not a contractionary policy. Do not confuse them.
⚠️ When two policy actions combine, determine which direction each pushes P and Y separately, then identify which variable changes unambiguously and which is ambiguous.
A rightward shift in the AD curve causes ______ (demand-pull / cost-push) inflation.
True or false: For sustained inflation to occur, the Federal Reserve must accommodate it by increasing the money supply. ______
Stagflation occurs when the ______ (AD / AS) curve shifts to the ______ (left / right).
True or false: If the economy is on the flat part of the AS curve, expansionary policy mostly increases the price level. ______
An inflationary gap exists when planned aggregate expenditure is ______ (greater than / less than) capacity output.
Answers: 1. demand-pull 2. True 3. AS, left 4. False (it mostly increases output) 5. greater than
Q: What is demand-pull inflation?
A: Inflation caused by a rightward shift in the aggregate demand curve. Increased spending pushes up both the price level and output.
Q: What causes cost-push inflation?
A: A leftward shift in the aggregate supply curve, typically from higher input costs (oil, raw materials, wages). The price level rises while output falls.
Q: If the economy is at full capacity, what does an increase in government spending do?
A: It raises the price level but does not increase output. Government spending completely crowds out private investment because there are no spare resources to absorb the extra demand.
Q: Suppose the economy is at potential output and the government increases spending. What happens in the short run and the long run?
A: Short run: the economy moves above potential output, and the price level rises (AD shifts right along the upward-sloping SRAS). Long run: input costs rise, AS shifts left, output returns to potential, and the price level is higher than before.
Q: What is the policy dilemma created by an oil price shock?
A: The oil shock shifts AS left, causing both higher prices and lower output (stagflation). Expansionary policy would restore output but push prices even higher. Contractionary policy would lower prices but deepen the recession. There is no policy that fixes both problems at once.
Q: According to the "simple" Keynesian view, what happens if the economy has excess capacity and the government enacts expansionary policy?
A: Output increases, but the price level does not change (assuming the economy still has excess capacity after the policy). In the simple Keynesian model, the AS curve is flat below full capacity.
Q: What is hyperinflation?
A: Extremely rapid inflation. Examples include Bosnia in 1993 (prices rising 1% per hour) and Argentina in the early 1980s (approximately 2,000% per year). It is typically associated with massive, sustained monetary expansion.
Q: True or false – expansionary economic policies are things the government can do to increase aggregate demand or aggregate supply.
A: True. Expansionary policies include tax cuts, spending increases (shifting AD right), and supply-side measures like deregulation or encouraging investment (shifting AS right).
The inflation material here connects to the Phillips curve (Chapter 14 in many textbooks), which formalises the short-run trade-off between inflation and unemployment. The policy effectiveness discussion links to the broader Keynesian vs. classical debate: Keynesians emphasise that policy works when the economy is below capacity, while classical economists emphasise that the long-run AS is vertical and policy only affects prices. The monetary accommodation concept connects back to the Fed's tools covered in Chapters 10–11.
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