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Suppose in an economy which is producing at its potential output, the central bank decides to...

Suppose in an economy which is producing at its potential output, the central bank decides to implement an expansionary monetary policy. Using the AD-AS model, explain the effect that this policy will have in the short run, and in the long run. Illustrate your answer with a diagram.

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Answer #1

The full employment level of output is Qf.

When the central bank undertakes expansionary monetary policy,the LM curve shifts to the right.This lower interest rate and increases output.Consequently,AD rises which leads a rise in price.Output=Q1 is beyond full employment level.

When the price rises,workers demand more wages.We know that wage rate and level of employment are negatively related.So,when wage rises the firms higher less workers.As,a result the aggregate supply falls.AS shifts to the left to AS2.Price rises to P2 but output is back to full-employment level.

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