Question

Use the following information for the next 9 questions. You should draw a graph that depicts the situation below and use your picture to answer the questions. Assume that wages and prices are sticky and that we start at a long-run equilibrium. Assume that at this initial point, the growth rate of the money supply is 8%, the growth rate of the velocity of money is 0% and that the real economic growth rate is 5%. Now assume that the Federal Reserve has decided to increase the growth rate of the money supply by 4% and that the Federal Reserve leaves the growth rate of the money supply at this elevated rate.

Answer 1

Answer = 1%.

As per quantity equation,

M x V = P x Y

% change in M + % change in V = % change in P + % change in Y

[Point 1]

8% + 0% = % change in P + 5%

% change in P = 3% (Inflation)

[Point 2]

4% + 0% = 3% + % change in Y

4% = 3% + % change in Y

% change in Y = 1%

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with initial long-run equilibrium price level P0 and initial equilibrium real GDP and potential GDP Y0. When money supply rises, aggregate demand also rises, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

LRAS SRAS AD Po Yo Yi Y