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Aggregate Demand, Aggregate Supply, and...
Aggregate Demand, Aggregate Supply, and Monetary and Fiscal Policy

We can now utilize the AS/AD framework to examine the effects of monetary and fiscal policy on the economy. We will see that these effects depend not only on the type of policy enacted, but also on the level of the economy before the policy is initiated. For example, if the economy is significantly below potential GDP, on the flat part of the short-run AS curve, then expansionary policy may cause aggregate output to increase significantly with little inflation, as illustrated below:

fg13_01100_1_.gif

For more practice in understanding the impact of policy and its relationship to the state of the economy, try the following Smart Graph exercise:

active_mini.jpgActive Graph Level 2: Aggregate Supply and Aggregate Demand: Demand Side Inflation and Deflation

On the other hand, if expansionary policy is initiated when the economy is already at potential GDP, the result may be inflationary with little growth in aggregate output. This situation is illustrated in the following figure:

fg13_01200_1_.gif

If the increase in AD is due to the fiscal policy option of increasing government spending, the effect will be almost complete crowding out. The increase in government spending is matched by an almost equal decrease in investment spending. Thus, there is almost no net increase in aggregate output.

To further explore the impact of changes in aggregate demand on the economy, try the following Smart Graph exercise:

active_mini.jpgActive Graph Level 2: Short-run Instability: The slope of the Aggregate Supply curve

And the following Active Graph Exercise:

active_mini.jpgActive Graph Level 1: Shifts in Aggregate Demand Along the AS Curve



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