Question

An economy is in long-run macroeconomic equilibrium, with output at Yp, when the following aggregate demand shock occurs: The quantity of money in the economy declines and interest rates increase. What kind of gap (inflationary or recessionary) will the economy face after the shock, and what type of fiscal policies would help move the economy back to potential output?

This will cause an inflationary gap; an expansionary policy should be used.
	This will cause a recessionary gap; an expansionary policy should be used.
	This will cause an inflationary gap; a contractionary policy should be used.
	This will cause a recessionary gap; a contractionary policy should be used.

Answer 1

Ans: This will cause a recessionary gap; an expansionary policy should be used.

A decline in quantity of money and increase in interest rate would lead to fall in investment and consumption, and hence aggregate demand would fall. Hence, the AD curve will shift to the left. This is call a recessionary gap. They need to use expansionary fiscal or monetary policies like cutting taxes or reducing interest rates. In the example below, due to the shock AD shifts to AD1 for the short term. And after expansionary policies, it shifts back to AD2.