Suppose the economy is initially in long-run equilibrium The Fed enacts a policy

Question

Suppose the economy is initially in long-run equilibrium The Fed enacts a policy to decrease the discount rate. In the short-run, this expansionary monetary policy will cause: Price Level SRAS2 122 12 118 LRAS 114 112 A shift from SRAS2 to point D, with a higher price level and lower output. A. to SRAS, and a movement SRAS1 108 106 104 102 O B. A shift from AD2 to AD1 and a movement to point C, with a lower price level and the same output. AD 2 ° C. A shift from SRAS, to SRAS, and a movement 100 98 to point B, with a lower price level and higher output. 94 92 90 AD O D. A shift from AD1 to AD2 and a movement to point B, with a higher price level and higher output. 4 6 10 12 14 16 Real GDP (trillions of 2000 dollars)

Explanation / Answer

As it has been given that initially economy is at its long-run equilibrium and it is at point C where AD1, LRAS and SRAS1 curve intersects.

When the Fed decreases the discount rate, then borrowing from Fed become cheaper and banks borrow more and so the money supply increases in the economy and so the AD for goods and services also increases. Hence the AD curve shifts rightward from AD to AD1 and economy reaches at its new equilibrium level and new equilibrium point will be at point B where SRAS1 and AD2 intersects.

It means this Fed action leads to A shift from AD to AD1 and a movement to point B, with a higher price level and higher output.

Hence option D is the correct answer.

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