Question

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is
constant.
(a) What happens to the level of output and the price level in the short run and in the long
run?
(b) In light of your answer to part (a), what happens to unemployment in the short run and
in the long run according to Okuns law? Show your work

(d) In what direction does the real interest rate move in the short run and in the long run?

Answer 1

a) The price level will remain the same in the short run due to sticky wages and the output will decrease by 5%

In the long run, the prices are flexible so the price level will decrease by 5% and the output will go back to its initial level.

b) As per Okun's law, every 2% decrease in output will increase unemployment by 1%

In the short run,the 5% decrease in output will cause unemployment to increase by 1+1+.5 = 2.5%

In the long run real output and unemployment would return to their initial level.

d) As S=Y-C-G

so, when the output decreases, savings will fall which will cause the interest rates to increase in the short run.

In the long run, the output will go back to its initial level which will move the real interest rate back to its initial position as well.