Government expenditure: Can the Reserve Bank do anything to prevent inflation

caused by excessive government spending?

Large increases in government spending are sometimes associated with
increased inflation. Explain why, using the AD–AS diagram. Can the Reserve
Bank do anything to prevent the increase in inflation caused by excessive
government expenditure?

Large increases in government spending are potentially inflationary because

total demand might increase relative to the economy’s productive capacity.
In the face of rising sales, firms increase their prices more quickly, raising
the inflation rate.

The two panels of Figure 11.9 illustrate this process. Looking first at Figure
11.9(a), suppose that the economy is initially in long-run equilibrium at point
A, where the aggregate demand curve (AD) intersects both the short-run and
long-run aggregate supply lines (SRAS and LRAS) respectively. Point A is a
long-run equilibrium point, with output equal to potential output and stable
inflation. Now suppose that the government decides to spend more, perhaps
to honour spending promises made in an election campaign. Increased
spending such as this is an increase in government purchases, G, an
exogenous increase in aggregate expenditure. We saw earlier that, for a
given level of inflation, an exogenous increase in spending raises short-run
equilibrium output, shifting the AD curve to the right. Figure 11.9(a) shows
the AD curve shifting rightward, from AD to AD′, as the result of increased
government expenditure. The economy moves to a new, short-run
equilibrium at point B, where AD′ intersects SRAS. Note that at point B, actual
output has risen above potential, to Y > Y*, creating an expansionary gap.
Because inflation is inertial and does not change in the short run, the
immediate effect of the increase in government purchases is only to increase
output, just as we saw in the Keynesian cross analysis in Chapter 8, Section
8.1.
The process doesn’t stop there, however, because inflation will not remain
the same indefinitely. At point B, an expansionary gap exists, so inflation will
gradually begin to increase. Figure 11.9(b) shows this increase in inflation as
a shift of the SRAS line from its initial position to a higher level, SRAS′. When
inflation has risen to π′, enough to eliminate the output gap (point C), the
economy is back in long-run equilibrium. We see now that the increase in
output created by the increased government spending was only temporary.
In the long run, actual output has returned to the level of potential output,
but at a higher rate of inflation.
Page 285

Does the Reserve Bank have the power to prevent the increased inflation
that is induced by a rise in government spending? The answer is yes. We
saw earlier that a decision by the Reserve Bank to set a higher real interest
rate at any given level of inflation—an upward shift in the policy reaction
function—will shift the AD curve to the left. If the Reserve Bank aggressively
tightens monetary policy (shifts its reaction function) as the increased
government expenditure proceeds, it can reverse the rightward shift of the
AD curve caused by increased government spending. Offsetting the
rightward shift of the AD curve in turn avoids the development of an
expansionary gap, with its inflationary consequences. The Reserve Bank’s
policy works because the higher real interest rate it sets at each level of
inflation acts to reduce consumption and investment spending. The reduction
in private spending offsets the increase in demand by the government,
eliminating—or at least moderating—the inflationary impact of the higher
government spending.
We should not conclude, by the way, that avoiding the inflationary
consequences of higher government spending makes the increase spending
costless to society. As we have just noted, inflation can be avoided only if
consumption and investment are reduced by a policy of higher real interest
rates. Effectively, the private sector must give up some resources so that
more of the nation’s output can be devoted to government purposes. This
reduction in resources reduces both current living standards (by reducing
consumption) and future living standards (by reducing investment).

One explanation for why inflation could get out of hand in this period relates to the
lack of reliable information available to policymakers on the true state of the
economy. This led to mistakes in policy that could have been avoided had
policymakers been better informed. Orphanides (2003), for example, in a very
influential piece of research, has argued that the key to understanding the Great
Inflation is a slowdown that occurred in productivity beginning in the late 1960s
leading to a fall in potential GDP. However, up-to-date (or what are known as real-
time) data about what is happening to potential GDP are very hard to come by.
What policymakers saw at the time looked like an economic contraction. In fact,
when potential output falls the economy experiences not a contractionary output
gap but instead an expansionary output gap. Failure to appreciate this led
policymakers to adopt the wrong policies. To quote from Orphanides’ paper, ‘The
dismal economic outcomes of the Great Inflation may have resulted from an
unfortunate pursuit of activist policies in the face of bad measurement, specifically,
overoptimistic assessments of the output gap associated with the productivity
slowdown of the late 1960s and early 1970s’. We illustrate Orphanides’ argument
in Figures 11.13 and 11.14.
In Figure 11.13(a) we have drawn on the diagram what, according to
Orphanides’ argument, may have happened at the beginning of the Great
Inflation to economies such as Australia’s and the United States’ and inFigure
11.13(b) what policymakers thought was happening. The fall in the
economy’s potential GDP from Y∗1Y1* to Y∗2Y2*illustrated in Figure
11.13(a) was a consequence of a slowdown in productivity. The reasons why
productivity fell in the late 1960s and early 1970s are complex and still
debated by economists. However, there is widespread agreement that one
factor that made the slowdown all the worse was the rapid increase in oil
prices that followed military action in the Middle East in October 1973, a
classic example of an adverse inflation shock (see Section 11.5.2 Inflation
shocks)
A significant and sustained increase in oil prices reduces the stock of capital
equipment used by firms seeking to lower costs, thereby shifting the
economy’s potential GDP. An increase in inflation results from the
expansionary output gap and the economy’s aggregate supply curve shifts
upwards. In Figure 11.13(a) the result is a new long-run equilibrium point
at B.
The problem for policymakers at the time was that all they could observe
was the fall in GDP and the rise in inflation. Hindsight provides us with the
explanation that what was happening was a fall in potential GDP. However,
at the time the fall in GDP was widely interpreted as being the result of
adverse inflation shocks (such as the rise in oil prices) leading to a
movement along the AD curve from point A to point B; this is shown Figure
11.13(b).
You can see from Figure 11.13 that what happened and what policymakers
thought was happening imply exactly the same effects on real output and
inflation. Since falls in potential output had not been observed since World
War II, policymakers can perhaps be forgiven for not understanding that
what they were observing were the effects of a fall in potential GDP.
Nonetheless, there is an important difference in the two diagrams drawn
in Figure 11.13. InFigure 11.13(a), point B represents long-run equilibrium for
the economy with potential and actual GDP equal at Y∗2Y2*—there is no
output gap. However, in Figure 11.13(b), point B is perceived to be a short-
run equilibrium, characterised by a contractionary output
gap Y2−Y∗1Y∗1Y2−Y1*Y1*.
Page 290
What happened next was crucial. Policymakers, mistakenly thinking they
were observing a contractionary output gap, implemented expansionary
monetary and fiscal policies, pushing the AD curve to the right. Figure
11.14shows the effects, both in reality and as expected by policymakers.
Let’s start with Figure 11.14(b). This shows what policymakers expected to
achieve with the implementation of expansionary polices. Concern about
what was thought to be a contractionary output gap led to a conventional
Keynesian response, shifting the AD curve to the right from AD1 to AD2. The
anticipated result was a shift of the economy to a new long-run equilibrium
point at C. While the new inflation rate of π2, corresponding to the new
expected inflation rate at ‘potential’ output Y*, would be locked in, the payoff
would be the elimination of the contractionary output gap.
What happened is illustrated in Figure 11.14(a). Following the shift of the AD
curve from AD1 to AD2, a new expansionary output gap
opened, (Y1−Y∗2Y∗2)(Y1−Y2*Y2*), consistent with the economy being at
point C.
The result will be another increase in inflation, in this case to π3, an upward
shift of the economy’s short-run aggregate supply curve to SRAS3, and a
movement along the aggregate demand curve, AD2, from point C to a new
long-run equilibrium point D. Compared to what policymakers had expected,
as illustrated in Figure 11.14(b), the consequences of the expansionary
monetary and fiscal policies were higher inflation and lower output.
Moreover, because what had happened was a fall in potential output, there
was no contractionary output gap and hence no automatic fall in inflation.
This, according to Orphanides’ argument, resulted in the Great Inflation.

15.2 1. Starting from an initial steady-state, a slowdown on the rate of population

growth will result in there being more saving than replacement
investment, therefore net investment will be positive. The capital–labour
ratio will therefore begin to grow, leading to economic growth (an increase
in per capita GDP). This will continue until a new steady state is reached at
a higher capital–labour ratio than the initial situation. At the new steady
state, economic growth will cease. In terms of the Solow–Swan diagram,
the (RI/L)RI/L will rotate downwards (due to a lower value of n), and
the steady-state point will shift to the right.
Not the graph. But use as a reference
The production function:

𝑌 = 𝐾 0.5 𝐿0.5

the capital–labour ratio will grow (that is, Δ K L will be a positive number) only if the
total saving in the economy exceeds replacement investment. This makes perfect sense;
the capital–labour ratio will increase only when the total investment in the economy is
more than what is needed to replace depreciated capital equipment or to provide new
capital equipment for a growing population.

Equation 15.11 also, importantly, tells us the condition under which the economy will
achieve its steady state—recall that this is when there is no change to the size of the per
capita capital stock and hence no change in per capita output.
In countries such as the United States, where the Global Financial Crisis was associated with significant
falls in the value of the housing stock, as well as bear market conditions in the share market, household
wealth fell significantly

The Global Financial Crisis

Background briefing 6.1 described the Great Moderation, a sustained period of relative economic calm
beginning in the early 1990s. What a difference a few years make! Starting around 2007, we witnessed
an extraordinary turnaround in economic activity, with the worst economic contraction in many
countries since the Great Depression of the 1930s. This is especially true of the world’s largest economy,
the United States. According to the US National Bureau of Economic Research (2018), the US economy
entered recession in December 2007, with the trough occurring in June 2009. Other countries fared little
better, particularly those of Western Europe.

Australia, in contrast, performed relatively well. Figure 6.5 shows a comparison of real GDP for the
United States and Australia. To make the comparison easier, the two sets of data have been adjusted so
that each is expressed as an index in which the value of real GDP in the March quarter of 2007 is
represented by the value 100. Thereafter, movements in the respective indices reflect what has
happened to the two countries’ GDPs.

Figure 6.5 Australia and the United States in the Global Financial CrisisNote: Relative to the United
States, the performance of Australia’s real GDP has been strong.Source: FRED database, Federal Reserve
Bank of St Louis, http://research.stlouisfed.org/fred2; and Australian Bureau of Statistics, Income,
Expenditure and Production, cat. no. 5206.0.

The recession in the United States shows up starkly in these data. The observation for the June quarter
of 2009 is more than 4.5 per cent lower than the figure at the start of the recession (December 2007). In
contrast, Australia’s real GDP is 2.5 per cent higher in the June quarter of 2009 compared to the
December quarter of 2007.

Page 143

THE US RECESSION

As we discussed in Chapter 2, economists divide the users of the final goods and services that make up
real GDP into four categories: households, firms, governments and the foreign sector (i.e. foreign
purchasers of domestic products). Corresponding to the four groups of final users are four components
of expenditure: consumption, investment, government purchases and net exports. Three of these four
components declined in the United States during the last two quarters of 2008, at accelerating rates:

Consumption spending decreased by 3.8 per cent in the third quarter and by 4.3 per cent in the
fourth quarter.
 Investment spending fell by 1.7 per cent in the third quarter and by 21.1 per cent in the fourth
quarter.

Exports rose by 3 per cent in the third quarter but declined by 23.6 per cent in the fourth
quarter; imports shrank by 3.5 per cent in the third quarter and by 16 per cent in the fourth quarter.

The only component of real GDP to rise over this period was government expenditure, which rose by 5.8
per cent in the third quarter and by 1.6 per cent in the fourth quarter.

UNEMPLOYMENT

As one might expect considering our discussion of Figure 6.2, the GlobalFinancial Crisis saw increases in
the unemployment rate. Figure 6.6 shows the unemployment rate since the late 1970s. For comparison,
the figures for both the United States and Australia are shown. You can see that the unemployment rate
in the United States rose from 5.0 per cent in December 2007 to 9.9 per cent in December 2009. This
increase was reflected across all demographic and educational groups. An increase in the rate of
unemployment, albeit less dramatic, was also recorded in Australia. However, in the aftermath of the
crisis, as economic conditions improved, the normal historical pattern of the Unites States having a
relatively lower unemployment rate than Australia re-emerged.

Figure 6.6 Unemployment in the United States and AustraliaNote: Unemployment rose in the United
States and Australia in the wake of the Global Financial Crisis, although the rise was much stronger in
the United States.Source: Compiled based on Organization for Economic Co-operation and Development
n.d., ‘Harmonized unemployment rate: Total: all persons for Australia’ (LRHUTTTTAUM156S), retrieved
from Federal Reserve Bank of St Louis (FRED),
https://fred.stlouisfed.org/tags/series?t=australia%3Bunemployment; US Bureau of Labor Statistics n.d.,
‘Civilian unemployment rate’, retrieved from FRED, https://fred.stlouisfed.org/series/UNRATE/.Page 144

INFLATION

The only bright spot throughout the recession was the inflation rate. The inflation rate using the CPI is
shown as the blue line in Figure 6.7, which plots inflation rates since 2001.

Figure 6.7 US inflation rateNote: The Global Financial Crisis contributed to keeping inflation low in the
United States.Source: Compiled based on US Bureau of Labor Statistics n.d., ‘Consumer price index for
all urban consumers: All items’, retrieved from Federal Reserve Bank of St Louis (FRED),
https://fred.stlouisfed.org/series/CPIAUCSL; US Bureau of Labor Statistics n.d., ‘Consumer price index
for all urban consumers: All items less food and energy’, retrieved from FRED,
https://fred.stlouisfed.org/series/CPILFESL.

However, the inflation rate calculated directly from the CPI can be misleading as it can be unduly
affected by items that both have a large weight in the index and also behave in a volatile manner, for
example, food and energy. A more useful measure of the underlying inflation trend is the core rate of
inflation, which is equal to the inflation rate calculated from the CPI when food and energy prices are
removed. This measure was relatively steady throughout this period.
Reference

National Bureau of Economic Research 2018, ‘US business cycle expansions and contractions’,
www.nber.org/cycles/cyclesmain.html.

Why did the Global Financial Crisis cause a recession in the United States and other countries?

As discussed in Chapter 6, house prices grew very rapidly in the United States leading up to the Global
Financial Crisis. The upward trend in house prices ended in July 2006 and this set off a chain of events
that led to severe financial crisis in the United States in August 2007 and a worldwide financial panic in
late 2007 and early 2008. These financial crises led to sharp declines in aggregate demand throughout
the world, pushing the global economy into a deep recession.

We first focus on two questions. First, how was the fall in US house prices transmitted to the financial
markets? Second, why did financial markets stop functioning in early 2008?

The key connection between the decline in home prices and the meltdown infinancial markets is a
financial instrument known as a mortgage-backed security. A mortgage-backed security is a bond whose
value is determined by a pool of home mortgages. As the value of the mortgages rises the value of the
security rises, and when the value of the mortgages falls the value of the security falls as well. The
advantage of these securities is that they allow investors to spread their risk. That is, instead of a bank
holding on to every mortgage that it writes, it can sell the mortgage to another financial intermediary,
which then packages together many mortgages into a mortgage-backed security. Insurance companies,
investment banks and other commercial banks purchased these securities because they were thought to
be relatively safe investments. After all, the securities were backed by mortgages, and mortgages were
secured by real estate that could always be sold to pay off the bond holders.

Mortgage-backed securities were not entirely without risk, however. In order to protect themselves
from the riskiness of the securities, financial institutions purchased a form of insurance called a credit-
default swap. It works like this: suppose you hold a security that has a risk of default. For a small fee, a
company offers to pay you if the security’s issuer actually does default. If the security reaches maturity
and is paid off, the company gets to keep the fee. Unlike true insurance policies, however, the
government did not require issuers of swaps to put aside any reserves to cover defaults.

This would come back to haunt the financial markets, as we will see in the next section.

The stage was now set for declining house prices to affect the financial markets in a big way. As US
house prices began to fall in 2006 and 2007, holders of mortgage-backed securities started to sell their
bonds since they (correctly) thought that the value of these bonds would start to fall. This resulted in an
increase in the supply of mortgage-backed securities for sale, which decreased the price of the securities
and actually made them less valuable to those who continued to hold them. All of thefinancial
intermediaries who held mortgage-backed securities saw the value of their assets shrink as the value of
the mortgage-backed securities they held declined, so they started selling these securities even more
quickly in order to get them off their books, depressing the prices further.

The price of securities fell considerably because the value of the back-up assets such as houses also
saw a drastic decline. Due to the expectation of falling value of securities, people began selling these
securities, which depressed the prices further. Consequently, this caused losses in the portfolios of
financial intermediaries. When there is a crash in financial markets, financial institutions collapses,
firms go bankrupt and individuals are likely to default on their home loans.

The first signs of the trouble caused by mortgage-backed securities appeared in August 2007. A number
of financial intermediaries in Europe and the United States reported losses due to the declining value of
mortgage-backed securities in their portfolios. A large British bank, Northern Rock, failed, setting off a
banking panic in the United Kingdom. Northern Rock had aggressively purchased real estate debt (both
mortgages and mortgage-backed securities), and financial market participants started to ask questions
about the viability of other financial institutions that had made similar investments. Their attention soon
focused on even larger investment banks like Bear Stearns, Lehman Brothers and Merrill Lynch.

The first of these institutions to collapse was Bear Stearns, in March 2008. Bear Stearns’s share price had
been falling since mid-2007, when two of its hedge funds collapsed due to the decline in the value of
mortgage-backed securities.

By early March, Bear Stearns’s share price was rapidly approaching zero, and officials at the US Federal
Reserve became concerned that a Bear Stearns bankruptcy would have ripple effects throughout Wall
Street and the global financialsystem. As a result, the Federal Reserve arranged financing and loan
guarantees so that fellow bank JP Morgan Chase could purchase Bear Stearns and help it avoid
bankruptcy.

Page 181

Many observers at the time thought this then unprecedented deal would be the end of the problem. A
major investment bank had failed but the system was intact, and the Federal Reserve had proven that it
would take strong action to prevent a financial crisis. But investor confidence was still far from solid
when a second problem hit: on top of the declines in home prices, the US economy suffered a record
rise in crude oil prices. Figure 7.14 shows the magnitude of this oil price shock. Because supply in the oil
industry had been largely stagnant in the face of sharply rising global demand from China, India and
elsewhere, crude oil prices shot upward. In 2007, this increase in oil prices accelerated, more than
doubling in the year and a half between January 2007 and July 2008.

Figure 7.14 Monthly real crude oil prices, January 2000–July 2018Note: Problems in the US housing
industry were exacerbated by a significant increase in the real price of oil.Source: US Energy Information
Administration 2018, ‘Short-term energy outlook’, https://www.eia.gov/outlooks/steo/realprices/.

The effect of this oil price shock on financial markets was immediate. Many companies that were
dependent on oil for production and sales faced severe challenges; General Motors, Ford and Chrysler,
for example, saw slumping demand for their large cars and trucks as consumers tried to cut back on
petrol expenditures. Further, higher oil prices made new home construction even less attractive,
especially in far-flung places that required long commutes to work. The prices of these homes, already in
decline, fell even faster as a result of diminished demand.

As prices of homes fell and prices of oil-dependent activities rose, even more individuals began to
default on their home loans. Two pillars of the mortgage finance industry in the United States—Fannie
Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage
Corporation)—had been driven to the brink of bankruptcy by defaults. Fannie Mae and Freddie Mac
were US Government-sponsored private corporations that were the largest issuers of private home
mortgage loans in the world; the far-reaching implications of their potential failure caused the
government to take the extraordinary move of seizing operating control of the corporations on 7
September 2008.

Page 182

One week later, the US Government again had a tough decision to make. Lehman Brothers, one of the
oldest investment banks in the United States, had been a heavy investor in mortgage-backed securities;
as the value of these securities declined drastically, so did the company’s solvency. On 14 September
2008, the Treasury Department and the Federal Reserve allowed Lehman Brothers to enter bankruptcy.
This unprecedented decision set off a panic in the financialmarkets. Previously, many in the industry had
assumed that the government would automatically rescue troubled financial giants. If Lehman could fail,
who was next?

The answer came quickly. American International Group (AIG) was the largest issuer of credit-default
swaps. If these contracts had been true insurance contracts, government regulations would have
required that AIG put a minimum amount of money in reserve to cover losses if one of their contracts
failed. But sellers of credit-default swaps like AIG were not required to hold assets in reserve to cover
future claims, so many did not; when mortgage-backed securities began to fail and AIG’s default-swap
clients demanded payment virtually all at once, the company quickly ran out of money.

Because AIG’s debts to other financial firms were so large, policymakers feared that allowing it to go
bankrupt could touch off a chain of additional bankruptcies, resulting in a meltdown of the global
financial system—a meltdown far beyond the panic caused by the failure of Lehman Brothers. The
government felt that it had no choice but to intervene. On 16 September, just two days after the failure
of Lehman Brothers, the US Government announced that it would provide US$20 billion (later increased
to US$150 billion) in financing for AIG to prevent a domino-effect bankruptcy catastrophe.

At this point, it became startlingly clear that many of the United States’ oldest and largest financial firms
were on the brink of insolvency. On 18 September then US Treasury Secretary Henry Paulson proposed
the Troubled Asset Relief Program (TARP), under which the government would use public funds to buy
mortgage-backed securities and other ‘troubled’ assets from banks. If the banks no longer held these
problematic assets, the theory went, then they should be in a strongerfinancial position to weather the
turmoil successfully.

Public opinion was sharply divided on the merits of this ‘bank bailout’ plan. Many critics were
understandably reluctant to commit taxpayer dollars; others felt that not interceding would have even
worse repercussions. The debate raged on; by the time the US Senate and the House agreed on a
modified version of the plan on 3 October, the financial markets had almost ceased to function.

Since the beginning of the economic downturn, the US Federal Reserve had acted aggressively in an
effort to inject additional liquidity into the banking system to keep funds flowing for large corporate
investors as well as the average consumer. These measures, however, did little to defuse the economic
crisis in the short run. Banks were still charging three percentage points above the interest rate on US
Treasury bills on loans to each other; typically, the fee is 0.25, to 0.5, per cent. Companies that relied on
short-term debt could not get credit, and banks stopped making loans to even their most
creditworthy customers.

The effects of the panic trickled down from the major investment banks and financialmarkets to
everyday workers. It became difficult, if not impossible, for firms to hire new workers (or, in some
cases, even pay existing ones), purchase necessary capital, cover operating costs and produce goods
and services at the same rates as they had been able to in the past.

The bursting of the housing bubble and the panic of 2008 caused both businesses and households to cut
back on their spending in two ways. First, the financial market disruptions made it difficult for
businesses to borrow funds for investment spending and for consumers to borrow funds for
purchasing houses and cars. Second, thefinancial crisis increased the level of uncertainty about the
future, which led to a reduction in exogenous spending, or spending independent of output.
Analytically, this situation can be represented as a downward shift in the planned aggregate expenditure
(PAE) line shown in Figure 7.15, from PAE0 to PAE1. Suppose the economy was initially at point E. After
the shift in the PAE schedule, the economy is in a situation where PAE is less than actual output; the
natural response of businesses is to reduce production until their output again meets demand, moving
the economy to point F in Figure 7.15. At F, the economy is in a recession, with output well below
potential. Further, since output is below potential, Okun’s law tells us that unemployment has now
risen above the natural rate.

Page 183

Figure 7.15 The end of the US house price bubbleNote: The bursting of the US housing bubble and the
subsequent panic in financial markets led to a decline in planned aggregate expenditure.

Government expenditure: Can the Reserve Bank do anything to prevent inflation caused by excessive
government spending?

Large increases in government spending are sometimes associated with increased inflation. Explain why,
using the AD–AS diagram. Can the Reserve Bank do anything to prevent the increase in inflation caused
by excessive government expenditure?

Large increases in government spending are potentially inflationary because total demand might
increase relative to the economy’s productive capacity. In the face of rising sales, firms increase their
prices more quickly, raising the inflation rate.

The two panels of Figure 11.9 illustrate this process. Looking first at Figure 11.9(a), suppose that the
economy is initially in long-run equilibrium at point A, where the aggregate demand curve (AD)
intersects both the short-run and long-run aggregate supply lines (SRAS and LRAS) respectively. Point A
is a long-run equilibrium point, with output equal to potential output and stable inflation. Now suppose
that the government decides to spend more, perhaps to honour spending promises made in an election
campaign. Increased spending such as this is an increase in government purchases, G, an exogenous
increase in aggregate expenditure. We saw earlier that, for a given level of inflation, an exogenous
increase in spending raises short-run equilibrium output, shifting the AD curve to the right. Figure
11.9(a) shows the AD curve shifting rightward, from AD to AD′, as the result of increased government
expenditure. The economy moves to a new, short-run equilibrium at point B, where AD′ intersects SRAS.
Note that at point B, actual output has risen above potential, to Y > Y*, creating an expansionary gap.
Because inflation is inertial and does not change in the short run, the immediate effect of the increase in
government purchases is only to increase output, just as we saw in the Keynesian cross analysis in
Chapter 8, Section 8.1.

The process doesn’t stop there, however, because inflation will not remain the same indefinitely. At
point B, an expansionary gap exists, so inflation will gradually begin to increase. Figure 11.9(b) shows
this increase in inflation as a shift of the SRAS line from its initial position to a higher level, SRAS′. When
inflation has risen to π′, enough to eliminate the output gap (point C), the economy is back in long-run
equilibrium. We see now that the increase in output created by the increased government spending was
only temporary. In the long run, actual output has returned to the level of potential output, but at a
higher rate of inflation.

Page 285

Does the Reserve Bank have the power to prevent the increased inflation that is induced by a rise in
government spending? The answer is yes. We saw earlier that a decision by the Reserve Bank to set a
higher real interest rate at any given level of inflation—an upward shift in the policy reaction function—
will shift the AD curve to the left. If the Reserve Bank aggressively tightens monetary policy (shifts its
reaction function) as the increased government expenditure proceeds, it can reverse the rightward shift
of the AD curve caused by increased government spending. Offsetting the rightward shift of the AD
curve in turn avoids the development of an expansionary gap, with its inflationary consequences. The
Reserve Bank’s policy works because the higher real interest rate it sets at each level of inflation acts to
reduce consumption and investment spending. The reduction in private spending offsets the increase in
demand by the government, eliminating—or at least moderating—the inflationary impact of the higher
government spending.

We should not conclude, by the way, that avoiding the inflationary consequences of higher government
spending makes the increase spending costless to society. As we have just noted, inflation can be
avoided only if consumption and investment are reduced by a policy of higher real interest rates.
Effectively, the private sector must give up some resources so that more of the nation’s output can be
devoted to government purposes. This reduction in resources reduces both current living standards (by
reducing consumption) and future living standards (by reducing investment).

One explanation for why inflation could get out of hand in this period relates to the lack of reliable
information available to policymakers on the true state of the economy. This led to mistakes in policy
that could have been avoided had policymakers been better informed. Orphanides (2003), for example,
in a very influential piece of research, has argued that the key to understanding the Great Inflation is a
slowdown that occurred in productivity beginning in the late 1960s leading to a fall in potential GDP.
However, up-to-date (or what are known as real-time) data about what is happening to potential GDP
are very hard to come by. What policymakers saw at the time looked like an economic contraction. In
fact, when potential output falls the economy experiences not a contractionary output gap but instead
an expansionary output gap. Failure to appreciate this led policymakers to adopt the wrong policies. To
quote from Orphanides’ paper, ‘The dismal economic outcomes of the Great Inflation may have resulted
from an unfortunate pursuit of activist policies in the face of bad measurement, specifically,
overoptimistic assessments of the output gap associated with the productivity slowdown of the late
1960s and early 1970s’. We illustrate Orphanides’ argument in Figures 11.13 and 11.14.

In Figure 11.13(a) we have drawn on the diagram what, according to Orphanides’ argument, may have
happened at the beginning of the Great Inflation to economies such as Australia’s and the United States’
and inFigure 11.13(b) what policymakers thought was happening. The fall in the economy’s potential
GDP from Y∗1Y1* to Y∗2Y2*illustrated in Figure 11.13(a) was a consequence of a slowdown in
productivity. The reasons why productivity fell in the late 1960s and early 1970s are complex and still
debated by economists. However, there is widespread agreement that one factor that made the
slowdown all the worse was the rapid increase in oil prices that followed military action in the Middle
East in October 1973, a classic example of an adverse inflation shock (see Section 11.5.2 Inflation shocks)

A significant and sustained increase in oil prices reduces the stock of capital equipment used by firms
seeking to lower costs, thereby shifting the economy’s potential GDP. An increase in inflation results
from the expansionary output gap and the economy’s aggregate supply curve shifts upwards. In Figure
11.13(a) the result is a new long-run equilibrium point at B.

The problem for policymakers at the time was that all they could observe was the fall in GDP and the
rise in inflation. Hindsight provides us with the explanation that what was happening was a fall in
potential GDP. However, at the time the fall in GDP was widely interpreted as being the result of
adverse inflation shocks (such as the rise in oil prices) leading to a movement along the AD curve from
point A to point B; this is shown Figure 11.13(b).

You can see from Figure 11.13 that what happened and what policymakers thought was happening
imply exactly the same effects on real output and inflation. Since falls in potential output had not been
observed since World War II, policymakers can perhaps be forgiven for not understanding that what
they were observing were the effects of a fall in potential GDP. Nonetheless, there is an important
difference in the two diagrams drawn in Figure 11.13. InFigure 11.13(a), point B represents long-run
equilibrium for the economy with potential and actual GDP equal at Y∗2Y2*—there is no output gap.
However, in Figure 11.13(b), point B is perceived to be a short-run equilibrium, characterised by a
contractionary output gap Y2−Y∗1Y∗1Y2−Y1*Y1*.

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What happened next was crucial. Policymakers, mistakenly thinking they were observing a
contractionary output gap, implemented expansionary monetary and fiscal policies, pushing the AD
curve to the right. Figure 11.14shows the effects, both in reality and as expected by policymakers.
Let’s start with Figure 11.14(b). This shows what policymakers expected to achieve with the
implementation of expansionary polices. Concern about what was thought to be a contractionary
output gap led to a conventional Keynesian response, shifting the AD curve to the right from AD1 to
AD2. The anticipated result was a shift of the economy to a new long-run equilibrium point at C. While
the new inflation rate of π2, corresponding to the new expected inflation rate at ‘potential’ output Y*,
would be locked in, the payoff would be the elimination of the contractionary output gap.

What happened is illustrated in Figure 11.14(a). Following the shift of the AD curve from AD1 to AD2, a
new expansionary output gap opened, (Y1−Y∗2Y∗2)(Y1−Y2*Y2*), consistent with the economy being at
point C.

The result will be another increase in inflation, in this case to π3, an upward shift of the economy’s
short-run aggregate supply curve to SRAS3, and a movement along the aggregate demand curve, AD2,
from point C to a new long-run equilibrium point D. Compared to what policymakers had expected, as
illustrated in Figure 11.14(b), the consequences of the expansionary monetary and fiscal policies were
higher inflation and lower output. Moreover, because what had happened was a fall in potential output,
there was no contractionary output gap and hence no automatic fall in inflation. This, according to
Orphanides’ argument, resulted in the Great Inflation.

15.2 Starting from an initial steady-state, a slowdown on the rate of population growth will
result in there being more saving than replacement investment, therefore net investment will be
positive. The capital–labour ratio will therefore begin to grow, leading to economic growth (an increase
in per capita GDP). This will continue until a new steady state is reached at a higher capital–labour ratio
than the initial situation. At the new steady state, economic growth will cease. In terms of the Solow–
Swan diagram, the (RI/L)RI/L will rotate downwards (due to a lower value of n), and the steady-state
point will shift to the right.

Not the graph. But use as a reference

The production function:

Y=K^{0.5}L^{0.5}
 the capital–labour ratio will grow (that is, Δ K L will be a positive number) only if the total saving in the
economy exceeds replacement investment. This makes perfect sense; the capital–labour ratio will
increase only when the total investment in the economy is more than what is needed to replace
depreciated capital equipment or to provide new capital equipment for a growing population.

Equation 15.11 also, importantly, tells us the condition under which the economy will achieve its steady
state—recall that this is when there is no change to the size of the per capita capital stock and hence no
change in per capita output.

What happens to inflation???

The rate of inflation may increase or decrease. The reason why it tends to decrease is that
because firms are not selling as much as they want, they will reduce their prices or increase
their prices at a lower rate. In addition, there is also an expectation of falling prices as
house prices fall (I don’t know if this is relevant at all lol! :)). Hholding V and Y constant in
the short run, as people make less deposits in the bank, there is less money supply (M),
hence price level (P) will fall. (𝑀𝑉̅ = 𝑃𝑌̅) As a result, the inflation rate will decrease, and
the economy may even experience deflation.

The reason why inflation rate increases is because of an increase in oil prices during
recession.