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Analyzing Terrylandia's AD-AS Model: Inflationary Gaps and Policy Measures

This study examines the economy of Terrylandia, currently at an equilibrium above full employment. We analyze the effects of an increase in the money supply and a decrease in interest rates on the aggregate demand and supply graph. The short-run impacts include changes in real output (Y2) and price level (P2). The economy is facing an inflationary gap, where actual output surpasses potential output. To correct this, potential fiscal policy measures include reducing government spending, raising taxes, or cutting government transfers.

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Analyzing Terrylandia's AD-AS Model: Inflationary Gaps and Policy Measures

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  1. Sample AD-AS Problem • The economy of Terrylandia is currently operating at an equilibrium above full employment. • Draw a correctly labeled graph of aggregate and aggregate supply and show each of the following • Current equilibrium output (Y1) • Current equilibrium price level (P1) • Long-run aggregate supply

  2. LRAS Price Level SRAS P1 AD YF Y1 Real GDP

  3. Sample AD-AS Problem (cont’d) • Now assume that the quantity of money in the economy increases and interest rates decrease. • Show on your graph in part (a) how this affects each of the following in the short run. • Real output (Y2) • Price level (P2)

  4. LRAS Price Level SRAS P2 P1 AD2 AD YF Y1 Y2 Real GDP

  5. Sample AD-AS Problem • Is the economy facing a recessionary gap, inflationary gap, neither, or both? • What fiscal policy measures could the government implement to bring the economy to output at full employment?

  6. Solution (cont’d) • The economy is facing an inflationary gap as actual aggregate output is greater than potential. • The government could cut government spending, increase taxes, or decrease government transfers.

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