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.
Dr. Peter NavarroProfessor
