A sustained, exogenous increase in aggregate demand (an upward shift in the AD curve) would create an expansionary gap in the economy. A productivity growth, depicted by a rightward shift in the LRAS curve, should be able to offset the effect of an increase in AD had it increased with the same magnitude. However, at the same time, there was a slowdown in productivity growth in the economy. Therefore, the shift in LRAS was not as big as the shift in AD which put an upward pressure to the economy’s inflation rate as shown by figure 1 below:
It did not necessarily mean that the inflation rate was meant to go back to its original level (π0), it could be some point higher than that but it had to be somewhere between 2 – 3%. The response from the RBA to the problems above would be shown in the figure below.
There were four AD curves in the diagram. AD0 and AD1 were exactly the same as those in figure 1. AD2 and AD3 were there only to show that the RBA might shift the policy reaction function (and hence AD) with the magnitude of the shift being left at their own discretion. Had they wanted to restore the original inflation rate, they would have to shift the AD to AD3. If they deemed it impossible to shift the AD with such magnitude, they might have gone with a smaller shift. It did not matter that the economy did not go back to its original rate of inflation of π0 as long as π2 was still within the target range of 2 – 3%.
Question 2 (assuming underlying inflation = inflation in all the AD-AS curves)
Underlying inflation is a measure of inflation which rules out the one off effects such as natural catastrophe and the likes. This is a more accurate measure of the true inflation rate; hence it is also called the core inflation. The RBA would be more concerned with the underlying inflation rather than the CPI inflation. Normally, a high underlying inflation would lead to the RBA tightening monetary policy, i.e. increasing interest rate without any change in inflation rate. This was done in order to shift down the AD curve to bring down the inflation rate back to the target set by the RBA. Under normal circumstances, the AD curve would not shift itself downward; instead, it needed the RBA’s intervention. The following figure would show the aforementioned dynamics.
π0 B A SRAS0
πT C SRAST
As depicted above, the economy starts with an inflation rate above the target at π0. The RBA wanted it to be at πT instead, therefore, they tightened their monetary policy to shift the AD down. After the AD curve had been shifted down, the economy moved from point A to point B. From this point, the economy would have a self correction because...