Question

1. Use the AS-AD model to derive the effects of a reduction in MT:

2. Use the AS-AD model to derive the effects of a drop in animal spirits SP:

General Guide line

1. Show the effects on P, Y , r, C, I, N, and W/P:

2. Show the effects for the short run and the long run, and indicate which response is larger, whenever possible.

3. Show all steps using diagrams and formulas. No credit will be given for incomplete arguments.

Answer 1

1. A decrease in the nominal money stock leads to a lower real money stock at each level of prices. In the asset market, the increase in interest rates induces the public to hold lower real balances. It lowers the aggregate demand and thereby decreases the equilibrium level of income and spending. Also, higher interest rates discourage investment I because the cost of borrowing increases. The aggregate demand curve shifts lefttward in case of a monetary contraction. The reduction in money supply reduces price levels and real output, as less capital is available in the economic system. Also, as P goes down, real wages go up (W/P). Usually as P goes down, inflation also comes down.

Usually a change in AD leads to a short run change in output and unemployment will change, but not in the long run. This is because in the long run, prices have a chance to adjust fully and thus, real variables will not be affected in the long run.

2. Similarly, a drop in animal spirits is like a general pessimism in the air. Losing confidence in the market would lead to a decrease in consumer spending C, and firm's will start investing less i.e. I will also decrease. This leads to a leftward shift in AD as aggregate demand falls. This sort of situation occurs in a self fulfilling prophecy kind of way, with both price levels and output/incomes falling leading to a recession. As output falls, the interest rate falls as well: the lower investment demand reduces the demand for loans and borrowing pushing down the interest rate. This analysis follows the one above in part 1.