Question

If the central bank of Toyoashihara decides to increase money supply substantially by increasing its open
market purchases, answer the following questions regarding Toyoashihara’s economy.

a) Describe the impact of these open market purchases in Toyoashihara’s money market.
b) Use the AS-AD diagram to show the impact of the increased money supply on the Toyoashihara
economy in the short run (label the short run ESR). Show initial position, all curve shifts, and explain.
c) Explain what will happen to bring the economy back to long run equilibrium? (label the new long run
E2). (Show in your AS-AD diagram from part b).
d) What is the long run impact of the increased money supply on real wage in Toyoashihara?

Answer 1

a) Increasing money supply by purchasing bonds from the market through open market operations will shift LM curve to its right from LM to LM1. It will reduce rate of interest from "i" to "i1" and raise output level from "Y" to "Y1".

b) Rise in money supply will raise money holding with people which tends to raise willingness to pay for goods and raise aggregate demand in an economy. In short run, demand curve shifts to its right from AD to AD1 which will raise price from P to P1 and output from Y to Y1.

c) In long run, to bring economy to its long run output level of Y, aggregate supply curve shifts to its left from S to S1. It will raise price level further to P2 and bring output back to its initial level.

d) Increase in money supply will raise price level whcih will reduce real wage because consumers would be able to buy less units of goods using same money as before.