During 1999 and 2000, a debate raged over whether the United States was at or above potential GDP. Some economists feared the economy was operating at a level of output above potential GDP and inflationary pressures were building. They urged the Fed to tighten monetary policy and increase interest rates to slow the economy. Others argued that a worldwide glut of cheap products was causing input prices to be lower, keeping prices from rising.

By using aggregate supply and demand curves and other useful graphs, illustrate the following:

a. Those pushing the Fed to act were right, and prices start to rise more rapidly in 2000. The Fed acts belatedly to slow money growth (contract the money supply), driving up interest rates and pushing the economy back to potential GDP.

b. The worldwide glut gets worse, and the result is a falling price level (deflation) in the United States despite expanding aggregate demand.