The following graph shows the new Keynesian model for a hypothetical economy. Th

Question

The following graph shows the new Keynesian model for a hypothetical economy. The economy is currently at equilibrium at point A, where inflation is 3% and the real growth rate is 6%. This means that ADI is the current aggregate demand curve and SRAS1 is the current short-run aggregate supply curve. INFLATION RATE [Percentl LRAS 10 SRAS2 AD1 SRAS1 10 REAL GDP GROWTH RATE (Percent Now, suppose that the Fed decides to increase aggregate demand and, therefore, starts buying bonds in open-market operations. The monetary base increases and the interest rate decreases. The money supply increases through the multiplier process and the lower interest rates encourage investment and consumer borrowing. As a result, the aggregate demand curve shifts up and to the right by 2%. Fill in the following table to indicate what happens to each of the following in the short run and in the long run. Equilibrium Point Inflation Rate Real Growth Rate Initial In the short run In the long run 3% 6% Even though the Fed can increase the aggregate demand using its monetary tools-buying bonds, for example-it cannot precisely predict the amount by which aggregate demand increases. Which of the following are reasons why? Check all that apply Investment spending depends mostly on long-term interest rates. M1 and M2 hardly ever respond to the higher monetary base. There are time lags between the Fed's actions and the resulting impact on the aggregate demand

Explanation / Answer

Equilibrium Point Inflation rate Real Growth Rate Initial A 3% 6% In the Short run C 4% 8% in the long run B 5% 6% In the sort run there will be an increase in the investment this will increase the demand or output. And leads to a higher price. In the long run as price level rises thi will reduce the real money supply as result interest rate will rise and investment will fall. We will move to LRAS with high inflation. Fed cannoty predict because real output takes time to adjust.So option c.

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