Question

Illustrate using the Aggregate Supply/Aggregate Demand diagram the effect of an expansionary monetary policy on economic output and price level. Indicate the new equilibrium level.

Answer 1

Introduction

During a time of recession, usually the price levels in the economy fall. Thus having an impact on the overall levels of output in an economy falling.

A recession leads to a situation in which aggregate demand for products and services decline and this leads to layovers which in turn reduces the net disposable income of people in the country.

As a result, the government must subsequently stabilize the country since the market forces are usually not fit enough to do this on their own.

In such conditions, the government tends to follow what is known as an expansionary fiscal policy in which it reduces tax rates and interest rates to promote investment and fund generation therefore increasing the flow of money in the economy. This in turn effects the demand and increases both GDP and price levels.

This can be explained with the help of a diagram as follows:-

Explanation of the Graph:-

In the above graph, aggregate demand rises to thus increasing till full employment is reached. As a result prices increase and the overall demand rises hence affecting the supply thus also having positive effects on the gross domestic product which further rises.

Please feel free to ask your doubts in the comments section