Question

Using diagrams of the AD-AS framework and Philips curve, show and carefully explain how a

contractionary monetary policy impacts output, inflation, and unemployment in the short run.

Answer 1

Ans. Suppose the economy is initially at long run equilibrium with output level Y, price level P, unemployment rate at natural rate (u) and inflation rate p.

Price Level Inflation LRPC AS AS' Р p" P P" SRPC SRPC AD AD Output Y Y uu Unemployment

A contractionary monetary policy leads to a decrease in money supply in the economy which at given money demand causes interest rate to increase. This increases cost of borrowing decreases private investment spending and consumption spending. This decreases the aggregate demand for goods and services shifting aggregate demand curve to the left from AD to AD'. This decrease the price level from P to P' and decreases output from Y to Y'. Due to decrease in output, unemployment rate increases from u to u' and decreases inflation rate from p to p' moving along the short run philips curve (SRPC) to the right

In long run, a decrease in inflation will make production units to revise their expectation of inflation downwards. This will lead to increase in aggregate supply of goods and services shifting the aggregate supply curve rightwards from AS to AS'. This increases the output level back to full employment level of output Y and decreasing price level further to P". Also, due to revision of price expectations downwards, the SRPC shifts downwards to SRPC' and as the output is at full employment level, the unemployment rate reduces to full employment level as shown by the long run philips curve (LRPC) leading to further decrease in inflation.

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