DAD-DAS 1. Describe the short-term and long-term consequences of an increase in
ID: 1125268 • Letter: D
Question
DAD-DAS
1. Describe the short-term and long-term consequences of an increase in money demand in the standard DAD-DAS model.
2.assume that the monetary policy in the DAD-DAS model violates the Taylor principle: is a negative number close to 0. describe the short-term and long-term consequences of a negative demand shock in this case
3. go back to the stardard DAD-DAS model and modify another assumption: assume that the natural rate hypothesis doesn't hold and that the natural output Y is subject to hysteresis. describe the short-term and long-term consequences of a negative demand shock in this case.
Explanation / Answer
1. short-term consequence of an increase in money demand
If the money demand is high, the real interest rate is low. This may be due to lower nominal interest rate or higher inflation. Investors will not invest if the real interest rates are low. The money will be used for consumption. This may give rise to higher levels of production without investment through credit from the bank. Higher production and consumption may lead to higher growth rates. When the production cannot be increased without investment, inflation will increase. Supply and demand will both decrease as inflation increases.
the long-term consequence of an increase in money demand
Increase in money demand will lead to lower growth in the future if inflation increases and interest rates are high. To increase the rate of growth, inflation will have to be decreased. This will come about through an increase in interest rate. Efforts for decreasing the money demand in the short-term can lead to higher interest rates that will reduce the money demand. The rate of growth will not be high but inflation will remain low in the long-term.
In the long-term output, will decrease. Using the dynamic, AD-AS model and the Fisher equation, the output will decrease if interest rates and inflation are high. Negative demand shock brings about a decrease in output.
Output depends on the natural level of output, real interest rate, and, demand shock.
Y = natural level of output + interest rate sensitivity of demand ( real interest rate - natural rate of interest) + demand shock
2. Taylor principle
iff = inflation + 2 + 0.5(inflation – 2) – 0.5(GDP gap)
iff refers to the nominal federal funds' rate target
If the monetary policy violates the Taylor principle, due to a negative demand-shock; the real GDP rate will decrease. Short-term consequences of this are higher supply and lower prices. Inflation will thus decrease.
In the long-term, the federal funds' rate target matches the Taylor rule. This is because as the demand increases, production and inflation will increase again.
3. Short-term consequences
In case of a negative demand shock, if natural rate hypothesis does not hold, GDP and employment will go beyond the natural level of employment. Sudden decrease in demand and prices will lead to lower output. This output will be below the natural level of output Y.
Long-term consequences
Long-term unemployment that may not be structural in nature. Demand-shock brings about a lower level of output. This comes from a lower level of investment as demand decreases. Hysteresis is evident in the labour market long after a decline in consumption. It is difficult to reduce the level of unemployment.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.