Question

Economics:

Suppose the economy is in long-run equilibrium, with real GDP at $16 trillion and the unemployment rate at 5%. Now assume that the central bank increases the money supply by 6%.

a. Illustrate the short-run effects on the macro-economy by using the aggregate supply-aggregate demand model. Be sure to indicate the direction of change in Real GDP, the Price Level, and the Unemployment Rate. Label all curves and axis for full credit.

Answer 1

In the long run, aggregate supply (LRAS) curve is vertical at output = $16 trillion.

Natural rate of unemployment = 5%

LRAS SRAS1 SRASO ---- ---- ---- ---- - AD1 ADO YN Y1

At the initial long run equilibrium, output is fixed at Y_N (= $16 trillion) at price level of P₀.

Increase in money supply will cause the Aggregate demand (AD) curve to shift outward, from AD₀ to AD₁. In this short run equilibrium, both Price & Output will increase, pushing actual output beyond Y_N, to Y₁.

This will push up employment (decreasing unemployment from 5%) & increase the wage rate. As input costs increase, producers will cut back on production & output will again decrease until Y = Y_N, but at a higher price level of P_2.