More than once in our history government officials tried to slow rapidly rising inflation by instituting wage and price controls, in essence, making it illegal to raise prices. In terms of the model, which includes aggregate demand, short-run aggregate supply and long-run aggregate supply, describe what the intended result of the officials would be and what the likely result may be.

Question

What will be an ideal response?

Answer 1

The inflation the economy was experiencing had to be the result of either rightward shifts in aggregate demand or leftward shifts in the short-run aggregate supply curve. The wage and price controls were likely intended to stop the leftward shift in the short-run aggregate supply curve since higher input costs lead to these leftward shifts. The controls could also slow the rightward shifts in aggregate demand if they were accompanied by slower money growth or if they caused people to hold more money (decreasing the velocity of money). The actual results, though, are many and often not what was intended. If inflation couldn't adjust, eventually current output would decrease, workers would not continue to work longer hours without raises or the likelihood of receiving one soon. The result could actually be a decrease in potential output, which would make shortages even more likely. Experience also points to the fact that when the controls are removed, input costs increase dramatically and inflation increases, (moving the short-run aggregate supply curve upward). In the long run the economy will return to its potential level of output where current inflation equals expected and target inflation. Since wage and price controls cannot increase potential output, in the long run they cannot be beneficial.