Question

42 Assume that there is no unanticipated inflation and that wages and prices are flexible. What will happen to short run real gross domestic product (RGDP) and the price level in the long run if the Federal Reserve purchases government securities in the open market? RGDP 10] Price Level 2 (A) Decrease 2 Decreased (B) No change Increase of GA () (C) No change Decrease CAO (D) Increase A No change 2 ) (E) Increase Increase 2A (5)

Answer 1

It is assumed that economy is initially in the long run with short-run real GDP at its potential level.
When Federal Reserve purchasesgovernment securities in the open market then it leads to the increase in the money supply in the economy.

This increase in money results in a decrease in interest rate.

As interest rate decreases, the cost of borrowing also decreases.

As the cost of borrowing decreases, households and firms borrow more for consumption and investment spending.

This leads to increase in aggregate demand.

Given the short-run aggregate supply, this increase in aggregate demand, in the short-run, leads to increase in price level and real GDP.

Over time, this increase in price level compels the workers to demand higher wages to protect their real wages.

As wages increases, the cost of production of firms increases which reduces their profit margin and compel them to decrease production.

Due to this aggregate supply decreases and short-run aggregate supply curve shifts leftward and new long run equilibrium is attained at potential real GDP and higher price level.

So,

In the long-run, there is no change in the short-run real GDP and an increase in the price level if the Federal Reserve purchases government securities in the open market.

Hence, the correct answer is the option (B).