Question

suppose The Fed has observed the economy is experiencing demand-pull inflation in a positive output gap. Discuss the monetary policy process and tools that can be used to address an inflationary output gap. DC picked graphically the impact of these policy actions in the AD-AS model. What happens to the equilibrium price level and output level?

Answer 1

Inorder to deal with such inflationary gaps the government and central need to implement a tight monetary and fiscal policy like increasing the interest rate or lowering government spending or raising taxes. An increase in the interest rate would make consumers spend less on durable goods and housing. These monetary tools can be increasing the cash reserve ratios by the federal banks with the commercial banks, open market operation taking place where government securities are sold in the market. This will take out money from the market and lead to lowering the purchasing power.  

In the below figure you will see that the demand pull inflation led to the increase in the demand to AD1 an price P2, quantity Q2 with equilibrium at e2. When the government applies the policy, the equlibrium price is not restored but stops at P3, Q3 and equilibrium at e3. You can see the image