3. Traditional monetary and fiscal policy-the AS-AD view Consider an economy des

Question

3. Traditional monetary and fiscal policy-the AS-AD view Consider an economy described by Figure 9-10, with out- put lower than the natural level of output and the nominal interest rate at zero. a. Draw Figure 9-10 and explain why the AD curve has a ver- tical portion. b. If the Federal Reserve increases the money supply, what will happen to the AS-AD diagram you drew in part (a)? Will equilibrium output move closer to the natural level? c. Given your answers to part (b), what policy options are available to the government to try to increase output? onsider traditional policy options only, and not financial policies. How does your answer relate to the policy deci- sions of the Obama administration and the U.S. Congr in February 2009? ess

Explanation / Answer

a)

The AD curve is a vertical line showing inelastic demand, i.e. demand is unresponsive to changes in price.

b)

With an increase in money supply, spending power of consumers will increase, as they will have more money in hands. As a result, demand for goods and services will increase, shifting the AD curve to the right, pushing it more closely to the natural rate of output and increasing the price.

(Graphically, it is shown as the rightward shift of the AD curve to the yellow dotted line)

c)

Output will already increase with increased money supply. The only way to decrease prices or control inflation is to increase AS. This will shift the AS curve to the right and thus reduce inflation.

This can be done by: Increasing productivity, R&D, technological innovation etc.

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