Question

Aa Aa 4. The effect of Bank of Canada action (or inaction) in the AD-AS model Consider the following graph. The economy is currently producing at point A (grey star symbol), which corresponds to the intersection of the AD1 and SRAS1 curves. The Bank of Canada is considering whether to intervene in an effort to bring the economy back to its potential PRICE LEVEL 180 LRAS SRAS 175 If Bank Intervenes 170 SRAS1 165 160 155 150 AD2 145 140 0.8 1.0 1.2 14 1.6 1.8 20 2.2 2.4 REAL GOP ITrillions of dellars) According to the graph, the potential output of this economy is Since real GDP is currently $2.0 trillion (as shown by point A), this level of potential output means there is currently of an expansionary gap Since the actual Along SRAS1, wages would have been negotiated based on an expected price level of price level at point A is 155, this means that real wages are had been negotiated, which will unemployment. If the Bank of Canada does not intervene, these labour market conditions would , shifting the_ Eventually, the curve to the cause nominal wages to economy would reach a new long-run equilibrium. On the previous graph, place the red point (cross symbol) at the new long-run equilibrium output and price level if the Bank of Canada does not intervene. (Assume there are no feedback effects on the curve that does not shift.) Now suppose the Bank of Canada chooses to intervene in an effort to move the economy more quickly back to its potential output. To do so, the Bank of Canada will interest rate, thereby giving firms an incentive to which will the money supply, investment, shifting the the curve to the On the previous graph, place the black point (X symbol) at the new long-run equilibrium output and price level if the Bank of Canada intervenes in this way and successfully brings the economy back to long-run equilibrium. (Again, assume there are no feedback effects on the curve that does not shift.) Compare your answers from the previous few questions. If the Bank of Canada does not intervene, the economy will likely have relatively high causing relatively high On the other hand, if the Bank of Canada does intervene, it risks , especially if it changes the money supply too much unemployment inflation

Answer 1

(a) Potential output = $1.6 trillion (corresponding to LRAS).

(b) Since real GDP is $2 trillion (> Potential GDP), there is an expansionary gap.

(c) Along SRAS1, expected price level is 150. Since actual price level is 155, real wages are lower than what is negotiated, which will increase unemployment. If Bank of Canada does not intervene, it will cause nominal wages to decrease, shifting the SRAS curve to the left (from SRAS1 to SRAS2).

(d) Without intervention, equilibrium is at intersection of AD1, SRAS2 and LRAS.

PRICE LEVEL 180 175 170 165 160 55XT No Intervention LRAS SRAS If Bank Intervenes SRAS1 AD AD2 145 140 08 1.0 12 14 1.6 18 2.0 2.2 2.4 REAL GOP ITrillions of dollars) Help Clear AlL

(e) To intervene, Bank of Canada will decrease money supply, which will increase interest rate, giving firms incentive to decrease investment, shifting AD curve to the left (from AD1 to AD2).

(f) With intervention, equilibrium is at intersection of AD2, SRAS1 and LRAS.

(g) If Bank of Canada does not intervene, economy will have high inflation. If Bank of Canada does intervene, it risks causing high unemployment.