Question

Question 2.4. (20 points) Over the last few units of this class, we've discussed how most economists agree that monetary neutrality holds in the long run but not in the short run. Let's explore this concept. (a) (5 points) Draw a graph of an economy in its long-run equilibrium. You should be sure to include both the long-run and short-run aggregate supply curves as well as the short-run aggregate demand curve. Label the long-run equilibrium price level and the level of output. (b) (5 points) Suppose that the Fed reduces the quantity of money in the economy. What effect does this change have on aggregate demand? In other words, how does the aggregate demand curve shift as a result of this change in policy? Draw a new graph showing this effect. (c) (5 points) Refer to your answer from part (b). In the short run, when wages are sticky, what happens to output and prices in as a result of the Fed's action? (d) (5 points) In the long run, workers' wages begin to adjust and firms are better able to allocate resources. Suppliers react to these changes, and the economy moves back towards its long-run equilibrium. Draw a new graph that shows this. Be sure to reference the long-run aggregate- supply curve from your answer in part (a). How does the new long-run equilibrium compare to the original equilibrium in terms of output and price level?

Answer 1

a) Suppose the economy is in long run equilibrium with output Y1 and price level P1.

b) After the FED uses monetary contraction, money supply decreases amd at the given money demand leads to increase in interest rate. This increase in interest rate increases the cost of borrowing reducing investment and consumption in the economy which leads to decrease in aggregate demand shifting the AD curve to left from AD1 to AD2.

c) The decrease in aggregate demand for given level of aggregate supply leads to a surplus in the economy which drives the price level downwards from P1 to P2 and leads to decrease in output level from Y1 to Y2.

d) In long run, due to lower price level firms expectations of inflation change in downward direction and because of lower price level, cost of inputs fall increasing profits of the firms. Both these affects induce production increasing aggregate supply shifting short run aggregate supply curve to the right from SRAS1 to SRAS2. This decreases proces further to P3 and increases output back to long run level Y1. Thus, moneytary policy afrcts only price level in the long run.

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