Describe cost-push inflation in the extended aggregate demand and aggregate supply model. Explain the policy dilemma for government policy if they take no action or use monetary and fiscal policy to counter the cost-push inflation.

What will be an ideal response?

Assume that the economy is initially in equilibrium at the full-employment level of real output. Also assume that there is a major increase in the price of a major resource (e.g., oil) for the economy. In this case, the price level rises because of a decrease in the short-run aggregate supply curve caused by this increase in the price of a major resource. This cost-push event will cause a movement along the aggregate demand curve to a short-run equilibrium at a higher price level, but lower level of output.
If the government takes no action to counter the inflation, then a recession will occur that will lead to higher levels of unemployment. At some point, the price of the major resource that caused the inflation will decline along with nominal wages (because of the recession), so that the short-run aggregate supply curve shifts back to its original position.
If the government tries to counter the cost-push inflation and recession by using stimulative monetary and fiscal policies, it will shift the aggregate demand curve to the right. The action will increase employment and real output to its full-employment level, but the price level will now be even higher. The higher price level is likely to kick off another round of demands to increase nominal wages that will cause another leftward shift in the short-run aggregate supply curve. Thus, an inflationary spiral can result from government actions to increase aggregate demand to counter cost-push inflation.