Question

Monetary Policy in Keynesian Models of the Macroeconomy

(c) Part of the challenge of monetary policy is that the level of potential output is not observed. Assume that the economy is in an equilibrium with output equal to potential output. Suppose the latest economic news leads the central bank to incorrectly raise their estimate of potential output. Use the AD-AS model to describe what will happen to output and inflation in both the short run and long run as a result of this mistake. Explain your reasoning in full.

Answer 1

An incorrect estimation of potential output, assuming it is higher than it really is, will make central bank wrongly believe that the economy has a recessionary gap, so aggregate demand and real GDP are lower than potential GDP level. In this case, to increase aggregate demand and GDP, the central bank will use expansionary monetary policy and increasemoney supply. An increase in money supply will lower interest rate, which will boost investment. An increase in investment will increase aggregate demand. AD curve will shift to right, raising both price level and real output, giving rise to an inflationary gap in short run. In the long run, higher price level will raise wages and prices of inputs, thus raising production costs. Firms will reduce output, lowering aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real output and removing the short-run inflationary gap.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect one another at long-run equilibrium price level P0 and real output (potential output) Y0. When aggregate demand increases, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real output Y1, with short run inflationary gap of (Y1 - Y0). In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real output to potential output level Y0, removing the short-run inflationary gap.