Question

Assume the United States is operating below full employment.

1. Identify one monetary policy tool that will solve the problem.
2. Using a correctly drawn and labeled AD/AS graph and money market graph, show and explain how the policy you identified in (a) will affect each of the following in the short-run:
   1. output and employment
   2. price level
   3. interest rates
3. Explain how the policy you identified in (a) will affect each of the following:
   1. International value of the dollar
   2. American exports (based on the changing value of the dollar)

Answer 1

A) Expansionary monetary policy would be used to bring the economy to its long run equilibrium point.

B) An Expansionary monetary policy works by increasing money supply in the economy. An increase in money supply leaves people with more income in hands, leading to an increase in their purchasing power and thus demand for goods and services, shifting AD curve to the right.

As one can see, AD curve shifts to the right to AD1

GDP reaches its long run equilibrium output of Q2

Price level rises.

Coming to graph for money market, money supply curve shifts to the right to MS1. This leads to a fall in interest rates.

Thus,

Output and employment: Increase

Price level: Increase

Interest rate: Decrease

C)

Due to increased supply of dollars in the economy,

International value of dollar will fall (dollar will depreciate)

American exports will increase, as US made products will appear cheaper in foreign markets due to dollar depreciation