To fight an ongoing 10% inflation, the government makes raising wages or prices illegal. However, the government continues to increase the money supply (and hence aggregate demand) by 10% per year. The economy starts at full-employment output, which remains constant.
a. Using the Keynesian AD-AS framework, show the effects of the government's policies on the economy. Assume that firms meet the demand at the fixed price level.
b. After several years in which the controls have kept prices from rising, the government declares victory over inflation and removes the controls. What happens?