Answer to Question #123987 in Macroeconomics for Ingrid

Question

Financing the government’s support package is a contentious issue. Part of it is to come from
reprioritisation of spending, part from an IMF loan and part from new debt issued in the local bond
market. Some have suggested that the Reserve Bank should simply print the money. Apply the
augmented Philips curve policy lesson to the suggestion that the SARB prints the money. Make use of
graphs and explain what the impact might be on output and inflation.

Answer 1

The AD/AS framework implies two ways that inflationary pressures may arise. One cause is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the aggregate supply curve. In the diagram below , there is a shift of aggregate demand to the right. The new equilibrium  E1 is at a higher price level than the original equilibrium E0. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level

Another source is a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor. This situation can cause the aggregate supply curve to shift back to the left. In diagram B above, the shift of the SRAS curve to the left also increases the price level from P0 at the original equilibrium E0 to a higher price level of P1 at the new equilibrium E1. In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.