Question

4. The long-run effect of Federal Reserve action (or inaction)in the AD-AS model

The following graph shows the short-run aggregate supply (SRASSRAS) and aggregate demand (ADAD) curves for a fictional economy that is producing at point A (grey star symbol), which corresponds to the intersection of the AD1AD1 and SRAS1SRAS1 curves.

No InterventionIntervention6789101112131414013012011010090807060PRICE LEVELQUANTITY OF OUTPUT (Trillions of dollars)SRAS2SRAS1AD2AD1LRASA

According to the graph, actual output of this economy is   than potential output, which means that the economy experiences   .

Along SRAS1SRAS1, wages would have been negotiated based on an expected price level of   . Since the actual price level at point A is 90, this means that real wages are   had been negotiated, which will   unemployment.

If the Fed does not intervene, these labor market conditions would cause nominal wages to   , shifting the     curve to the   . Eventually, the economy would reach a new long-run equilibrium.

On the previous graph, place the purple point (diamond symbol) at the new long-run equilibrium output and price level if the Fed intervenes. (Hint: Assume there are no feedback effects on the curve that does not shift.)

Now, suppose the Fed chooses to intervene in an effort to move the economy more quickly back to its potential output. To do so, the Fed will   the money supply, which will   the interest rate, thereby giving firms an incentive to   investment, shifting the   curve     .

On the previous graph, place the green point (triangle symbol) at the new long-run equilibrium output and price level if the Fed does not intervene and successfully brings the economy back to long-run equilibrium. (Hint: Assume there are no feedback effects on the curve that does not shift.)

Compare your answers to the previous few questions. If the Fed does not intervene, the economy will likely have relatively     . On the other hand, if the Fed does intervene, it risks causing relatively     , especially if it changes the money supply too much.

Answer 1

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