Question

The mid-to-late 90s in the United States were characterized by increasing productivity, increasing wealth, and very optimistic firm and consumer expectations for the macroeconomy. The period became known as the “New Economy” and some overzealous economists even proclaimed that recessions were a thing of the past and we were now on a path of permanent expansion and prosperity. Using the Income-Expenditure model along with the AS/AD model, show and discuss the Short Run effects, and predict any future Long Run effects policymakers would be concerned about.

What kind of Monetary Policy should the Fed use to deal with the concerns you identified above? Show the effects using the Income-Expenditure model along with the AS/AD model, and summarize the expected changes in our big 3 indicator variables. (Income, Unemployment rate, inflation rate)

Answer 1

Refer to the figure below. It shows that LRAS is long run aggregate supply and this also shows economy potential. When economy has a positive boom then Aggregate demand shifts to right from AD1 to AD2. Real GDP increases from Yf to Ye. This also shows average price levels going up from Pf to PLe. This shows inflationary impact on short run. According to monetarists economy comes back to equilibrium in the long run. The reasons are as average prices increase then wages also go up and also the overall inflationary impact makes suppliers to supply less and hence Aggregate supply shifts back to left and again equilibrium is achieved again at price level PL2.

Policy makers are always concerned whether economy will come back to equilibrium or not. Economy may overheat if increased demand is not met with increased supply and unrest may occur.

During this inflationary impact govt. adopts contractionary fscal policy in which taxes are raised and govt. investment is reduced. This helps AD to shift back from AD2 to AD1 as shown in diagram above. It can also be supported by contractionary monetary policy in which interest rates are raised and money supply is reduced. This may make average price level to go down from PLe to Pf and unemployment to grow with reduction in real GDP from Ye to Yf.