1) Consider the following in the context of the quantity equation and the ASAD m

Question

1) Consider the following in the context of the quantity equation and the ASAD model where the shortrun supply curve is horizontal and the long run supply curve is vertical. Suppose that the Central Bank decides that the economy is in danger of entering a period of high inflation and that it must cut the nominal money supply by 5% to preempt it.  

a) In percentage, what is the shortterm impact on output?

b) In percentage, what is the shortrun impact on the price level?

c) In percentage, what is the longrun impact on output?

d) In percentage, what is the longrun impact on the price level?

e) Explain what happened.

Explanation / Answer

Considering the fact that quantity equation of money relates money supply velocity of money price level and output, if there is an increase in the money supply by 5% there will be several consequences.

We are given that the long run supply curve is vertical and the short run supply curve is horizontal. In this sense there will be no change in the price level in the short run and hence, the entire increase in the money supply will be reflected in the output level. So in the short run output increases by 5% while price level does not increase. In the long run price level increases by 5% and output does not increase.

This analysis results in an observation that in the long run output cannot be increased beyond its full employment level. Short run prices are a sticky they do not change for any increase in the money supply.

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