What economic events and policies led to the emergence of the U.S. economy from the stagflation of the late 1970 and early 1980? Depict the effect of these events using the extended AD–AS model.

What will be an ideal response?

First, the Fed practiced restrictive monetary policy to get inflation under control. Second, the recession of 1981–1982 increased unemployment, so many workers received lower nominal wage increases or wage reductions during this period. Firms restricted price increases to maintain market shares. Foreign competition also held down domestic wage prices and price hikes in industries such as automobiles and steel. A decline in OPEC’s monopoly power and a reduction in U.S. dependence on oil in production caused a large fall in oil prices. Combined together, these events and policies reduced per-unit production costs and shifted the short-run AS curve outward.
In terms of the extended AD–AS model, the tightening of monetary policy would have raised interest rates, shifting the AD curve in. For AS, the reduction in nominal wages and reduced dependence on oil in production would have caused a large outward shift in AS, helping to reduce prices and bring output back to equilibrium level.