Question

2. Aggregate demand

a. Write down the AD relation.

b. Use the IS-LM model to derive the AD curve. What could cause the shift of AD curve?

3. Monetary expansion

a. Assume the economy is initially at Yn. Draw the AD-AS model and label the initial equilibrium as A. Draw the corresponding IS-LM model and indicate the equilibrium A.

b. Suppose now there is a monetary expansion. Show the short run effect on price level, output, and interest rate in your diagrams. Label the short run equilibrium as A1.

c. In the medium run, the adjustment of price expectations comes into play. Explain the adjustment process in words. Show the adjustment process in your diagrams and label the medium run equilibrium as A2.

d. Explain the neutrality of money.

4. Fiscal expansion or contraction

a. Assume the economy is initially at Yn. Draw the AD-AS model and label the initial equilibrium as A.

b. Suppose now there is a fiscal expansion/contraction. Show the short run effect on price level and output in your diagram. Label the short run equilibrium as A1.

c. Explain the adjustment process in words. Show the adjustment process in your diagrams and label the medium run equilibrium as A2.

Answer 1

Answer to 2 (a)

Aggregate demand (AD) is the demand for all commodities made by all the consumers in the market. AD is affected by many factors of the market. One of the major factors affecting AD is the price of the commodity. There exists a negative relationship between the price of the commodities and AD of the commodities. In other words, the AD curve shows the relationship between the price level in the economy and GDP of the economy.

Answer to 2(b)

The IS-LM model examines the relationship between output, or GDP, and interest rates. Where IS stands for Investment Saving curve and LM stands for Liquidity Money Curve. It shows the equilibrium of goods and money market.

It can be graphically depicted as follows:

Above diagram shows that IS and LM curve intersects at point E. i is the equilibrium interest rate and y is the equilibrium output.

We will derive the AD curve, which shows the negative relationship between the aggregate level of price in the economy and the level of national income.

Let's assume that the nominal money supply, which is represented by M/P where M is the money supply and P is price level in the economy, remains constant.

Let's suppose that there is a change in the price level, i.e. P, and it rises. If P rises, the nominal money supply will decrease, which will shift the LM leftwards. Above diagram shows the equilibrium state of the economy where i0 is the equilibrium interest rate, Y0 is the equilibrium output. It also shows that at price P0 output is Y0. When the price increases to P1, it decreases the nominal money supply and shifts the LM curve leftwards. With the leftward shift of LM curve interest rate changes to i1 and output level shifts to Y1. It means that at a new price level P1 output is Y1. By joining the two combinations of price and output marked as E0 and E1 in the second part of the graph, we derive the AD curve.

Answer to 3 (a) and (b)

The graph mentioned above shows that the economy is initially at Yn. at this level of output, the interest rate is i.

With the expansion in the monetary policy in the economy, the money supply will increase, which will shift the LM rightwards. These changes can be shown in diagram mentioned-below.

In the diagram mentioned-above, the changes in the economy due to the monetary expansion is shown by shifting LM curve rightwards. Due to the rightward shifting of LM curve equilibrium point changes from point A to point A1, interest rate decreases from i to i1 and output increases from Yn to Yn'.