The Building Blocks of Keynesian Analysis

Self-Check Questions

Use the AD/AS model to explain how an inflationary gap occurs, beginning from the initial equilibrium in Figure.

Hint:

An inflationary gap is the result of an increase in aggregate demand when the economy is at potential output. Since the AS curve is vertical at potential GDP, any increase in AD will lead to a higher price level (i.e. inflation) but no higher real GDP. This is easy to see if you draw AD1 to the right of AD0.

Suppose the U.S. Congress cuts federal government spending in order to balance the Federal budget. Use the AD/AS model to analyze the likely impact on output and employment. Hint: revisit Figure.

Hint:

A decrease in government spending will shift AD to the left.