Question

. Initially, the economy was in its long-run equilibrium. Then, consumers’ preference for consumption fell; they became consuming less at any price level.

.a. Because of the consumption change, how would the curves of LRAS, SRAS and AD shift in the short-run: Leftward, Rightward, or No shift? How would the output and the price would change in the short-run: Decrease, Increase, or No change?

              SRAS:

              LRAS:

              AD:

              Output:

              Price:

.b. Consider the monetary policy response to maintain the full employment. Answer what changes and shifts the policy response would cause.

              Change in money supply: Decrease, Increase, No change

              Change in interest rate: Decrease, Increase, No change

              Shift of LRAS: Leftward, Rightward, No shift

              Shift of SRAS: Leftward, Rightward, No shift

              Shift of AD: Leftward, Rightward, No shift

Answer 1

a.

Below diagram depicts this situation:

Intital equilibrium is at point E where LRAS, SRAS and AD curve intersect each other. There will be no change in the positions of SRAS and LRAS. A decrease in the consumption will lead to fall in the aggregate demand. So, AD curve will shift to left from AD to AD1. Consequently, Price and output will fall from P* to P1 and Yp to Y1

SRAS: No Change

              LRAS: No change

              AD: Shift to left

              Output: Decrease

              Price: Decrease

b.

In order to maintain the full employment, expansionary monetary policy would be adopted. This will increase the flow of money into the economy and boost the demand.

Change in money supply: Increase

              Change in interest rate: Decrease

              Shift of LRAS: No shift

              Shift of SRAS: No shift

              Shift of AD: Rightward