Question

Suppose the US economy is at Potential GDP. Then, consumers and firms become pessimistic about future economic conditions, and consumption and investment decrease. In response to the decline in consumption and investment, the FED increases the money supply. Congress responds as well approving an increase in government spending and tax cuts. Illustrate this sequence of events using an Aggregate Demand/Aggregate Supply graph. State what happens with Real GDP, Prices, and the Unemployment rate after monetary and fiscal policies are implemented.

Answer 1

After monetary policy and fiscal policy is implemented, then AD increases and real GDP achieves its potential level of output. Unemployment also decreases and it reaches to the level of natural rate of unemployment. But, the price level increases further at the potential level of output and there are high price level in the economy.

Step by by step movement in the economy is shows as follows:

State 1: Economy at potential output State 2: When people and firms get pessimistic State 3: Economy reaches potential output due to monetary and fiscal policy Price LRAS Price LRAS Price LRAS - - SRAS SRAS SRAS Z AD ADNAD ADID real GDP Q1Q State 2 real GDP State 1 real GDP State 3