Suppose there is a sustained, exogenous increase in aggregate demand. Using theaggregate-demand/aggregate supply model, explain why the Governor (and the Boardof the Reserve Bank) might be concerned...

Solution
An economy undergoing a situation of continuous rise in aggregate demand will be suffer
from accelerating inflation levels due to excess demand. This can be shown by the following
diagram:
In the figure above as the demand shifts from AD1 to AD2, the price level rises from P1
to P2. When the economy is below the full employment level (given by Yfe in the diagram) this
rise in price level will induce the producers to increase supply. Thus they would employ more
factors to increase their level of operations. Thus the supply shifts from SAS1 to SAS2. They are
the short run supply curves which are upward sloping while the long run supply curve LRAS is
vertical as the supply is independent to price level changes in the long run.
The above diagram shows that in the short run any rise in AD will cause both equilibrium
output and price level to rise. But in the long run any exogenous increase in AD will only raise
the price level leading to...