Question

Using aggregate demand and aggregate supply, explain what happens in the short run if the Federal Reserve raises interest rates in the economy. Be sure to detail what happens to aggregate demand, the price level, the level of GDP, and unemployment.

Answer 1

If fed raises interest rate, it leads to lower investment and lower consumption (the portion of consumption funded by borrowing), which decreases aggregate demand, shifting AD curve leftward and reducing both price level and real GDP. as a result, unemployment rises.

In following graph, AD0 & SRAS0 are initial aggregate demand & short run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As Ad shifts left to AD1, it intersects SRAS0 at point B with lower price level P1 and lower real GDP Y1.