Question

4. In a closed economy, if an economy's current output Y is Yn and monetary expansion is adopted, what will happen to the output and price level in the short-run and median-run. Will AD and AS shift and when will the adjustment end? Use an AD-AS diagram to explain your answer. 20%

Answer 1

Short run impact An increase in the money supply is associated with a decline in the rate of interest. This stimulates investment spending and hence, aggregate demand in goods market increases. As the AD curve shifts to the right, there is an increase in the general price level as well as an increase in the real GDP. In this manner, in the short run, money is not neutral because it is able to increase the real GDP which is a real variable. Medium run impact As price has increased, real wage starts decreasing. Workers experience their real wage rate decreasing and so the market fails to restore equilibrium. Firms then revise nominal wage (now higher to match the price rise) contract with rising prices. Firms will hire fewer labor when wage contracts are revised and price expectations are changed. Hence the economy experiences a leftward shift of the AS curve where a new equilibrium is determined. Production is decreased but price has increased further. Real GDP returns to its full employment equilibrium which shows that in the long run money is neutral as it cannot change real variables.

Price level ASI AS AD1 Yf _Y1 Real output There is no adjustment once the long run equilibrium is established. AS and AD will not shift after the adjustment unless there is an exogneous shock to the economy.