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The Federal Reserve expands the money supply by 5 percent:

a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate.
b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change
in the interest rate on output and the price level in the short run.
c. When the economy makes the transition from its short-run equilibrium to its new long-run equilibrium, what will happen to the price level?
d. How will this change in the price level affect the demand for money and the equilibrium interest rate?
e. Is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run?

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Sonal Bahl
Sonal BahlLv10
22 Mar 2021
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Related questions

An increase in the money supply will:
ย 
A. not change theโ€‹ long-run aggregate supply curve but ultimately will only raise the price level inโ€‹ the long-run equilibrium price level.
B. move the equilibrium point along theโ€‹ short-run aggregate supply curve.
C. shift the aggregate demand curve outward and to the right.
D. All of the above.

A) Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = $1.0. The aggregate demand curve is Y = 2(M/P) and M = 1,500.

i) If the economy is initially in long-run equilibrium, what are the values of P and Y?

ii) What is the velocity of money in this economy?

iii) If M increases to 2,000, what are the new short-run values of P and Y?

iv) Once the economy adjusts to long-run equilibrium at M = 2,000, what are P and Y?

B) Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = $1.0. The aggregate demand curve is Y = 3(M/P) and M = 1,000.

i) Suppose a supply shock moves the short-run aggregate supply curve to P=$1.5. What are the new short-run P and Y? What will be the new long-run P and Y?

ii) Suppose that immediately after the supply shock the Federal Reserve Bank wanted to hold output at its long-run level. What level of M would be required? If this level of M were maintained, what would be long-run equilibrium P and Y?

C) Use the aggregate demand/aggregate supply model to illustrate graphically the impact in the short run and the long run of the following changes. (Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values). Also, state what happens to prices and output in the short run and the long run.

i) The Federal Reserve Bank engages in expansionary monetary policy.

ii) Climate change causes reduced food production.

iii) Labor unions are banned.

Suppose the economy is in a long-run equilibrium:

a. Draw a diagram to illustrate the state of the economy.

b. Now suppose a stock market crash causes aggregate demand to fall. Use your diagram to show what happens to the price level and the output in the short run. What happens to the unemployment rate?

c. Use the sticky wage theory of aggregate supply to explain what will happen to the price level and the output in the long run(assuming there is no change in policy). What role does the expected price level play in this adjustment? Be sure to illustrate your analysis in a graph.

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