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Price Level

Policies to promote economic growth
Short run

How?
LRAS

Expansionary fiscal/monetary policy






E2
Pl2

Pl1

E1

BUT

AD2




AD1
Y1

Y2 Real GDP

Long run

Price Level

Increase in Government spending/ reduction in taxation
Decrease in interest rates or exchange rate
Increase money supply
As AD increases, actual growth increases from Y1 to Y2
Extra benefit  Dual effect on AD & AS



Demand pull inflation
Depends on initial level of economic activity – the more
spare capacity, the greater chance AD will increase growth
Consumer confidence, size of multiplier, time lag etc…

How?
LRAS

LRAS1

Supply side policies




Improve education, subsidise businesses etc…
Increase in potential and actual growth
Extra benefit  Dual effect on AD & AS

BUT

Pl1

AD1
Real GDP

Time, cost, no guarantee of working + depends on initial
level of economic activity
The more spare capacity, the more an increase in AD, not
AS, is needed

Policies to reduce unemployment
Cyclical (demand deficient)


Expansionary monetary/fiscal policies
...
g
...
g
...
Contractionary monetary/fiscal policies
a
...
Increase interest rates and exchange rates, reduce money supply
c
...
Conflict of lower growth and higher unemployment
ii
...
Level of consumer confidence
2
...
Size of multiplier
4
...
Protectionist measures
a
...
g
...
BUT
i
...
Imported inflation
iii
...
Allow currency to depreciate – allow central bank to reduce interest rates or sell currency on
forex market
a
...
BUT
i
...
Imported inflation – ass imports become more expensive
4
...
Increase productive capacity of economy, thus bringing downward pressure on prices,
reducing cost push inflationary pressure, and in doing so exports may become more
competitive, which may increase the demand for exports and reduce the current
account deficit problems that a country may be experiencing

b
...
Take a long time, may not work, expensive, depends on initial level of economic
activity, opportunity cost, etc…
HOWEVER, it can be argued that if the current account deficit is only a small percentage of GDP, then
the government does not need to get involved and implement these policies, thus avoiding their
potential side effects
...
SRAS  costs of production
2
...
Short Run equilibrium AD = SRAS
4
...
Short Run where wages are fixed
6
...
When workers accept higher or
lower wages

SRAS

Pl1

AD
Y1

Price Level



Real GDP

In the long run an economy will always beat the full
employment level of output
...
If quantity and quality of factors of production
increases, the curve can shift to the right (and to the left if decrease)
...
In order to shift supply back to full level of
employment, producers need to find a way to lower their costs
...
There may be a minimum
wage, or unemployment benefits are high, in a way that cutting
wages would then disincentivise people to work, or there may be
strong trade unions
...




AD1
AD2
Y2 Y1

Real GDP

Fall in output
Increase in unemployment

In long run, wages become variable, as workers start to realise
that it may be due to their high wage expectations that they are
unemployed, and thus start accepting lower wages, decreasing
firms’ cost of production, and shifting SRAS back to long run
equilibrium
...
It may seem that the economy is producing beyond
the level of full employment of resources
...
Or this can be due
to currently employed workers working harder or overtime
...
In the long run, workers realise that they have bargaining
power due to inflation, and thus demand higher wages, increasing
the cost of production, and shifting SRAS back to long run
equilibrium
...


Pl3
Pl1
Pl2

B
A
C

When SRAS shifts, maybe due to shocks,
SRPC will shift to the opposite direction

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