Question

2. Suppose that we are in a world where short-term prices are sticky, but not fixed. The Fed decides that it wants to increase output. A.) According to the Phillips curve, what is the short-run/long-run tradeoff that the Fed is making in this situation? (quid pro quo, Clarice?) B.) What must the Fed do to the money supply? C.) Describe the graphical changes that take place in the market for real money. D.) In the short-run, what happens to interest rates? E.) Describe the graphical effects that this policy will have in the AD-AS model. F.) Does the model demonstrate the neutrality of money concept? How?

Answer 1

Q2) A) When the Fed wants to increase the output, there is a significant increase in the aggregate demand. This will lead to an increase in output, as well as a reduction in unemployment. But, then there is a short run/long run trade off between unemployment and inflation. So, even though the unemployment falls, the inflation in the economy increases.

B) The Fed has to increase the money supply in order to increase output. This is known as expansionary monetary policy. It can do so by lowering the reserve requirements for the banks. This will help them lend out more money in the economy. So, there will be more consumption, more investment, increase in aggregate demand which will subsequently increase the output in the economy.

C) The Fed can increase money supply through open market purchases of govt bonds or by decreasing reserve requirement. So, at point E, there is real money supply Ms/P and interest rate is i, when money supply is increased, the curve shifts to the right, there is an increase in real money supply Ms'/P since price P remains sticky and constant. This gives way to new equilibrium, the real money supply increases from level 1 to 2. The equilibrium interest rate falls from i to i'. Take a look at fig.

Interest wa Ms IP Rate / Mslp Scanned by TapScanner !T E E' L (14) O 1 2 Real Pronow

D) So, in the short run, the increase in money supply and real money supply causes the interest rates to fall in the economy. This is the short run effect of the money supply increase, i.e. before it impacts price level in the economy.

As per rules, have answered the first four sub parts of the question.