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The economy is currently experiencing an economic boom with low unemployment and high output. The Federal...

The economy is currently experiencing an economic boom with low unemployment and high output.

The Federal Reserve could conduct contractionary monetary policy to restore the economy to its natural rate of output.

Draw and upload a graph of the Aggregate Demand and Aggregate Supply model to illustrate the impact of the contractionary monetary policy in returning the economy to the natural level of output.

Be sure to carefully label all components of your graph.

Briefly explain how the contractionary monetary policy works to have the effect that you have shown in the Aggregate Demand and Aggregate Supply model above.

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Answer #1

As a result of the contractionary monetary policy by fed , the money supply in the economy will reduce. This will lead to the reduction in consumption and investment. As a result the AD curve will shift to left from AD to AD1. Initially the economy was under inflationary gap with equlibrium at E. After the reduction in AD , the new equlibrium is E1 which is the equilibrium point of economy in short run and even in long run. Hence the equilibrium in economy is restored.

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