Question

Suppose the economy is in long-run equilibrium, with real GDP at $16 trillion and the unemployment rate at 5%. Now assume that the central bank increases the money supply by 6%.

a. Illustrate the short-run effects on the macro-economy by using the aggregate supply-aggregate demand model. Be sure to indicate the direction of change in Real GDP, the Price Level, and the Unemployment Rate. Label all curves and axis for full credit.

Answer 1

When the central bank uses expansionary monetary policy and increases money supply, it will decrease interest rate, which will stimulate investment. Higher investment will increase aggregate demand. AD curve will shift to right, raising both price level and real output, giving rise to an inflationary gap in short run. Higher real GDP will lower unemployment rate.

In following graph, price level (P) and real GDP (Y) are depicted vertically and horizontally, respectively. Initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect one another at long-run equilibrium price level P0 and real output (potential output) Y0. When aggregate demand increases, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real output Y1, with short run inflationary gap of (Y1 - Y0).