For each scenario below, start by drawing an economy in long-run equilibrium, la
ID: 1234796 • Letter: F
Question
For each scenario below, start by drawing an economy in long-run equilibrium, labeling theinitial equilibrium price level and equilibrium quantity of real GDP. Be sure to label your axes as
well. Then, shift the appropriate curve short-run curve (note: leave the LRAS curve fixed, as we
primarily use the AD-AS model to depict short-run changes), and label the new short-run
equilibrium price and equilibrium quantity. Briefly explain why you chose to move the curve(s)
you did and why it shifted in the direction it did. Finally, state what happens overall to the price
level and real GDP.
a. There is a decrease in household wealth.
b. Consumers start to expect lower future incomes.
c. There is a negative supply shock, such as due to a flood or earthquake.
d. There is a decrease in personal income taxes.
e. There is a decrease in interest rates, at the same time that there is an increase in wage
rates, and the effect of the interest rate increase is stronger than the effect of the wage
increase.
f. There is an increase in government spending at the same time that there is a decrease
in the price of oil and the two effects are equal in magnitude.
Explanation / Answer
Four factors influence the demand for money: ? The price level — An increase in the price level increases the nominal demand for money. ? The interest rate — An increase in the interest rate raises the opportunity cost of holding money and decreases the quantity of real money demanded. ? Real GDP — An increase in real GDP increases the demand for money. ? Financial innovation — Innovations that lower the cost of switching between money and other assets decrease the demand for money. An interest rate is the percentage yield on a financial security; other variables being the same, the higher the price of the security, the lower is the interest rate. The interest rate is determined by the equilibrium in the market for money, as illustrated in Figure 11.2. The real supply of money is $3.0 trillion, so the supply curve of money is MS. The demand curve for money is MD, and the equilibrium interest rate is 5 percent. ? If the Fed increases the quantity of money, the supply of money curve shifts rightward and the equilibrium interest rate falls. If the Fed decreases the quantity of money, the supply of money curve shifts leftward and the equilibrium interest rate rises The Fed’s actions ripple through the economy. Higher interest rates: ? Decrease investment and consumption expenditure ? Increase the foreign exchange price of the dollar, which then decreases net exports ? A multiplier process then occurs Real GDP growth and the inflation rate both slow when the Fed raises the interest rate. The opposite effects occur when the Fed lowers the interest rate. These effects are how the Fed influences the economy. The macroeconomic short run is a period during which some money prices are sticky and real GDP might be below, above, or at potential GDP. If real GDP exceeds potential GDP so there is an inflationary gap, the Fed tightens to avoid inflation. The Fed decreases the quantity of money, which raises the interest rate. The higher interest rate decreases interestsensitive components of aggregate expenditure, such as investment. The decrease in investment leads to a multiplier effect that decreases aggregate demand, thereby lowering the price level and decreasing real GDP so it equals potential GDP. If the Fed eases to avoid a recession, the reverse results occur. ? Long-Run Effects of Money on Real GDP and the Price Level The macroeconomic long run is a period that is sufficiently long for the forces that move real GDP toward potential GDP to have had their full effects. ? Suppose the economy is at its long-run equilibrium and the Fed increases the quantity of money. Aggregate demand increases and the AD curve shifts rightward, as illustrated in Figure 11.3. The price level rises, and real GDP increases. ? An inflationary gap exists and the unemployment rate is below than the natural rate. The tight labor market leads to a rise in the money wage rate. The short-run aggregate supply decreases, and the shortrun aggregate supply curve shifts from SAS 0 to SAS 1 . This situation is illustrated in Figure 11.4, wherein real GDP returns to potential real GDP ($10 trillion) and the price level rises still higher to 130. The quantity theory of money holds that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. The velocity of circulation is the average number of times a dollar of money is used in a year to buy goods and services in GDP. In terms of a formula, velocity of circulation, V, is given by V = PY/M, where P is the price level, Y is real GDP, and M is the quantity of money. M1 velocity has increased and fluctuated but M2 velocity has been quite stable.
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