Question

#1 ​Starting at a point of long term equilibrium.  

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​Suppose there is a massive increase in AD due to a rapid increase in consumption due to excess spending (over exuberant consumption)

​Using the ADAS model show, what will happen when AD shifts

​What will happen if the Fed does nothing?

​What policies should the Fed undertake?

​Show what will happen to interest rates on the Money Market graph

​What effect will this action have on interest rates and AD (show on the ADAS model)

#2 ​Starting at a point of long term equilibrium.  

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​Suppose there is a recession caused by falling AD due to a rapid reduction of consumption and business investment due to a panic in the financial markets. (This is what happened in the crash of 2008)

​Using the ADAS model, show the recession unfold on the graph as AD shifts

​What will happen if the Fed does nothing?

​What policies should the Fed undertake?

​Show what will happen to interest rates on the Money Market graph

​What effect will this action have on interest rates and AD (show on the ADAS model)

Answer 1

Aggregate demand = Consumption + Investment + Government Spending + Exports - Imports

Aggregate demand increases from its long run equilibrium due to rise in consumption level. It will shift aggregate demand curve to shifts to its right from AD to AD1.

If Fed do nothing, price will fall from P to P1 while output will rise from Y to Y1.

If Fed wants to maintain the initial long run equilibrium, they will adopt contractionary monetary policy which will reduce the level of aggregate demand by reducing the circulation of money in the economy and willingness to pay of goods.

Contractionary monetary policy will shift the LM curve to its left which will raise the rate of interest from "i" to "i1" and reduce the level of output from "Y" to "Y1".

It will cause aggregate demand to fall and reach its long run equilibrium of point A where Y goods were produced.