Question

Suppose the economy is initially at a long-run equilibrium. Then the central bank increases the money supply. Assuming any resulting inflation is unexpected, explain any changes in GDP, unemployment, and inflation in the short-run that are caused by the monetary expansion. Explain your conclusions using three diagrams: (i) one for the IS-LM model, (ii) one for the AD-AS model, and (iii) one for the Phillips curve.

Answer 1

i)

Monetary expansion policy Increase money supply and shift LM curve to right.

New LM curve intersect IS at new equilibrium,where GDP is higher and interest rate is lower.

ii)

Increase in Money supply Increases real income of people causing Increase in aggregate expenditure and Aggregate demand curve shift right .

The new AD curve intersect SRAS at new equilibrium,where GDP is higher than potential GDP and prices is higher.

iii)

Initial Equilibrium was at Point A where long run Philip curve interesect short run Phillips curve.

As GDP Increases , unemployment Decrease ,which lead to increase in price level and inflation,so economy move from point A to B .

At Point B unemployment is lower than natural rate of unemployment and inflation is higher.