Question

Assume that a negative demand shock hits the economy. Assume The Fed does not take any action. What will happen to output and the price level in the long run? Explain why this action may be undesirable.

How could The Fed use policy to return the economy to its potential level of GDP (output)? Describe which curve in the AD-AS model would shift and in which direction?

Assume that the action taken by The Fed in part b causes output to increase by 5%. Using Okun’s law, how much will unemployment change by?

Answer 1

When a negative demand shock hits the economy, output and price false since the demand curve shifts to the left which creates recessionary gap(gap between Y1 and Y0) and increases unemployement, the effect of this is only during the short run so even if fed does not take any actions it self adjusts in the long run, hence doesn not effect the price and output in the longrun.

To return the economy to its full employment the Fed will use and expansionary monetary policy, itis done by increasing the supply of money in the economy. Fed will purchase bonds and reduces reserve ration which increases the lending power of banks and a decrease in interest rates will encourage more borrowings and increase investments to produce more output and increase employement returning the economy to its potential level of GDP.  

If you look at the above graph, when Fed practices expansionary monetary policy the AD1 shifts to the right to AD2 at full employementand ant to potential level of GDP at Y0.

According to Okuns law 1% increase in unemployement causes 2% fall in GDP, the equation is as follows

y-y*/y* =-2(U-U*)

5%=-2(U-U*)

=-2.5%

Therefore 5% increase in GDP causes 2.5% reduction in Unemployment.