Question

Assume that the US economy is initially at equilibrium with the intersection of AD curve, LRAS curve and SRAS curve.

1. Explain, using diagram, how a boom in the stock market will affect the initial equilibrium and the following macroeconomics variables: Output, Price, and employment.

2. Using the diagram explain how the Fed should respond to this situation in order to stabilize output and employment.

Answer 1

LRAS SRAS Price level \ADI AD Y Y1 Real GDP

a). Initially the economy is at the equilibrium where the aggregate demand , short run aggregate supply and the long run aggregate supply were equal. This is the point 'E', so when there is a stock market boom people's income will increase in the country and that will increase the consumption and investment activities. Since the consumption and the investment are the components of the aggregate demand , the aggregate demand will increase. This is shown by the rightward shift of the aggregate demand curve , the increase in the aggregate demand would increase both the price level and the real GDP. The price level would increase P to P1 and the real GDP would increase from Y to Y1.

b). So here the country is having an inflationary gap, the inflationary gap occurs when the current level real GDP outweighs the full employment level of GDP. For bringing back the economy to a full employment level, the Fed should introduce a contractionary monetary policy, that is either a selling of government owned securities, increasing the discount rate or reserve ratio. When the Fed introduces the contractionary monetary policy the money supply would decrease in the economy and that would decrease the aggregate demand and the aggregate demand curve would fall back and the economy will be at the full employment level. This is shown by the below graph.

LRAS SRAS Price level AD1 Y Y Real GDP