Question 1: Suppose an economy is in equilibrium. a) Using aggregate demand and aggregate supply, illustrate...

Question 1: Suppose an economy is in equilibrium.

a) Using aggregate demand and aggregate supply, illustrate the equilibrium. Do not forget to include the long-run aggregate supply.

b) Now suppose the central bank decided to increase the money supply in the economy. Using the theory of liquidity preference and the money market graph, illustrate what is going to happen to the aggregate demand.

c) Draw the new short-run equilibrium of the economy, as a result of the shift in aggregate demand you considered in part b). What will happen to the output in the short-run? What will happen to the price level in the short-run?

d) Assuming no government intervention, show the long-run equilibrium. How did the economy adjust to this new long-run equilibrium point? Explain.

Solutions

Expert Solution

a) Diagram is given below showing Equilibrium in the Economy. Point E shows the Equilibrium.

b) When the money supply Increases, in the Money market diagram, money supply Curve shifts to right. Interest rate goes down. Aggregate Demand Increases and Aggregate Demand curve shifts to the right as shown in the Diagram below.

C) In the short run, Both Output and Price Level will increase as shown in the diagram above.

D) Adjustment towards the Long run Equilibrium leads the money Wages and Prices to fully adjust themselves because of which the Increase in money supply causes no Change in Employment and Output. Output remains at long run Equilibrium level, shown above by point E" in the Diagram above. However, Price Level Increases more than it Increased in the Short run.

Rahul Sunny answered 2 weeks ago

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