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The concept of the three ranges in the economy is important.

Because it identifies three distinct situations in which fiscal or

monetary policy may or

may not be used effectively to fight the problems of recession or inflation.

[SOUND] This figure illustrates these three ranges of the economy.

Here, we see that the horizontal, or Keynesian, range represents

a range where increasing output will not lead to any inflation at all.

In this range the economy is likely to be either in a severe recession or

a full blown depression, in which large amounts of unused machinery and

equipment, and unemployed workers, are available for production.

In such a case, putting these idle resources

back to work can be done with little or no upward pressure on prices or wages.

And it follows that in this Keynesian range, prices are for all practical

purposes fixed, and that's precisely why it is called the Keynesian range.

Because remember, in the Keynesian model, prices are assumed to be fixed.

Now, it should clear from looking at this flat portion of the curve,

the government can implement expansionary, fiscal, or

monetary policy to stimulate growth, with little fear of inflation.

Note, for example, that an increase in aggregate demand triggered by

expansionary government policies shifts output from Q1 to Q2.

But the price level remains the same.

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Now in contrast, in the vertical or classical range,

the economy has reached its full capacity level of real output at Q sub c.

In this range, any attempt to increase production further through a Keynesian

fiscal or monetary stimulus will not substantially increase real output but

merely lead to inflation.

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For example, you can see very clearly here that an increase in aggregate demand,

AD5 to AD6, does not increase Q sub c.

Instead, price level rises, P5 to P6.

And here's the key point, in this classical range,

expansionary fiscal and monetary policies will not be effective at all.

In fact any form of Keynesian stimulus, if it is tried,

the only result will be inflation, not an increase in GDP growth.

This is textbook demand-pull inflation because it is precisely outward

shifts in aggregate demand that are pulling up the price level.

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Let's look more closely now at the intermediate range of the economy

between Q sub u and Q sub c.

In this intermediate range,

any expansion of real output is also accompanied by a rise in price level.

And in this intermediate range scenario, policymakers always

face a tradeoff between seeking to stimulate more GDP growth,

a good thing, versus stimulating more inflation.

Which is usually a bad thing.

In fact, this intermediate range is much more typical of real world conditions.

The underlying problem is that the economy is comprised of the numerable product and

resource markets.

And as the business cycle moves from recession to expansion, and

from employment, movements in all these markets may not occur simultaneously.

For example, as the economy expands in the intermediate range, auto and

steel workers may still be unemployed.

However, the high tech computer and

software industries may begin to experience shortages in skilled workers.

At the same time, raw material shortages or

bottle necks in production may begin to appear in other industries.

Thus, even though there may be some recessionary slack in parts of

the economy, in other parts conditions may be conducive to cause an inflation.

[SOUND] This situation Is illustrated in this portion of our figure.

Here, real GDP begins with Q sub 3, but

it is below the full employment output, Q sub 4.

In this case, stimulating aggregate demand through expansionary physical or

monetary policy will indeed move the economy to Q sub 4.

However, it will also result in demand-pull inflation

as the price level rises from P3 to P4.

And to reiterate, that's the key point.

In the real world, fixing the problems of recession and

inflation are actually highly interrelated.

With that observation, let's move on to our next and last module of this lesson.

In which we will take a fun look at various strategies both business

executives and investors can use to hedge against the negative effects of inflation.

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When you're ready, let's move on.

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The Three Ranges of the Economy

Strategic Business Management - Macroeconomics

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