Question

Can you graph the following scenario taken from the headlines recently about the German economy – (Bloomberg Markets - Feb 14, 2018). With your graph please provide a rationale in support of your graphical analysis.

“The euro-area’s largest economy finished with a positive output gap of 1% of potential GDP...It’s the only one among the euro-area’s four largest economies to operate above potential. The problem for central bankers is that the advanced situation in the cycle isn’t translating into rising inflationary pressure.”

-- Maxime Sbaihi and Jamie Murray, Bloomberg Economics

Answer 1

In the below graph we have ADAS model showing demand and supply in the economy. On the X axis we have output and on the Y-axis, we have Price of the product. Initially, the economy was at equilibrium at point "a", where the price was P and output Q.

After a positive output gap, the economy will be producing more than the potential level, which is represented by the LRAS curve. The output will increase and cause the SRAD curve to shift to the right at SRAD' after that shift the new economy is at equilibrium at point "b". The output is more than the potential level at Q' but the price has only increased marginally to P' and inflation has not occurred in the economy.