[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

in the ADI curve pushed the economy into a recession, with output at E 1 , below the
economy’s full-employment output at point E 0 . If the aggregate demand curve
remains at ADI 1 , inflation will eventually fall and the economy will reach full employment
at point E 2 with an inflation rate of π 2 . If inflation adjusts slowly, it may take
a long time for full employment to be restored. An expansionary fiscal or monetary
policy that shifts the aggregate demand curve to the right would push the short-run
equilibrium output level closer to full employment. If the ADI curve is shifted all the
way to ADI 0 , full employment is restored at the original rate of inflation, π 0 .
Shifts in the Inflation
Adjustment Curve
So far, we have concentrated on the impact of shifts in the ADI curve on the economy.
Such a focus is natural in that aggregate expenditures determine output (and
employment) in the short run, and inflation typically adjusts relatively slowly. But
economies also experience disturbances that directly affect inflation. Two of the
most important are changes in energy prices and shifts in potential GDP.
INFLATION (π)
E 1
π 0
Y f E 0
IA 0
π 1 IA 1
ADI 0
Figure 31.9
Y 1
OUTPUT (Y )
THE IMPACT OF AN INFLATION SHOCK
An increase in the cost of production at each level of
output increases the inflation rate, shifting the inflation
adjustment curve up, from IA 0 to IA 1 . The short-run equilibrium
is at the point of intersection between the inflation
adjustment and ADI curves. The upward shift in the
inflation adjustment curve moves the economy to E 1 ,
where output has fallen to Y 1 . If there are no further inflation
shocks, inflation declines because output is below its
full-employment level. Eventually, full employment and
an inflation rate of π 0 are restored.
CHANGES IN ENERGY PRICES
For a given level of cyclical unemployment, inflation can be affected by
shocks that alter firms’ costs of production. For example, during the
1970s, oil prices increased dramatically. Oil prices also rose substantially
in 2004, because of both greater demand for oil as the economies
of China and the United States grew and fears of disruptions in supply
as the fighting in Iraq continued. By raising the price of energy, an
increase in oil prices pushes up the costs of production. In response,
firms will raise prices, leading in turn to a jump in the inflation rate.
We can analyze the consequences of an inflation shock such as an
oil price increase using the ADI curve and inflation adjustment line. To
do so, suppose the economy is initially at full employment with an inflation
rate equal to π 0 . This condition is shown as point E 0 in Figure 31.9.
The inflation shock causes inflation to increase to π 1 , as shown by the
upward shift in the inflation adjustment curve to IA 1 . The new equilibrium
is at E 1 . Economic disturbances that shift the inflation adjustment
curve—inflation shocks—are often also called supply shocks.
The economy will not remain at point E 1 , however. Over time, inflation
will decline because the economy is operating below potential GDP.
As inflation falls, the IA curve shifts back down. Eventually, the equilibrium
returns to point E 0 , with the inflation rate and output back at their
initial values.
Supply shocks present policymakers with difficult choices. To prevent
output from declining and unemployment from rising, the central
704 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION