Question

2-) The Government observes a significant amount of unemployment in the economy. Some argue that the government should stimulate the economy in order to decrease the unemployment level using monetary policy.

a) Using the theory of liquidity preference, show the effects of expansionary monetary policy. What will happen to the interest rate? What will happen to the aggregate demand as a result? You must explain why we observe this relationship.

b) Draw the new short-run equilibrium of the economy. What happened to the price level, output and the unemployment level in the new short-run equilibrium?

c) How will the economy adjust in the long-run? Explain the transition and show it on a graph. What will happen to the price level, output and unemployment?

d) Show how the same economy will adjust in the short-run and the long-run using a Phillips curve this time. Use the same labels you used for the initial, the short-run and the long-run equilibrium that you used in part c).

e) Would you advise the government to undertake this policy considering your answers to part c) and d)? Why? What will be happening to the policy options in the long-run? Explain by talking about the trade-off options between unemployment and inflation.

Answer 1

1. Expansionary monetary policy leads to a lower interest rate. It has two sides. The aggregate demand side and the aggregate supply side. In the case of AS, lower rate of interest encourages firms to invest more, as a result production and employment increases. It creates aggregate demand in the economy. When people earn more income they will demand more goods and services. So that price and output will increase. These two are related when AS increases, that leads to an increase in AD and reached in a new equilibrium point.

2. The second question can be explained with the AD-AS model. A graph based on liquidity presence theory and B graph represents AD-AS model. Now the new equilibrium point is B where price falls to P1 and output increases to Y1.

3. Firms employ more workers and output increases. So AD shifts to the right, price and output increases to P* and Y* respectively. In the long run people realise their real wage falls from the initial stage and demands more wage leads to workers lay off by firms which shifts AS to AS2. output come to its natural level and price rises further to P4.

4. In the above graph both short-run and long-run Philips curve incorporated. Initial equilibrium point is A where price is stable and natural rte of unemployment there. When monetary expansion introduced, unemployment falls and price rises to P1. People are in a temporary money illusion. That is until stage they have experienced a price stability so they think that their real wage increses. So supply more labour and firms demand more labour so SRPC shifts to the right. Later workers realised that there were a fall in the wage rate, demanded for more wage lead to jobloss and the economy will reache in its Natural level. Here unemployment and price level or inflation increases.this process goes on.

5. Govt can adopt fiscal and monetary policies to reduce unemployment and increase aggregate demand, but in the long run there is no trade off between in inflation and unemployment. In the Short run they can attain their goal but in the long run unemployment comes to its normal level and price go up and leads to inflationary situations in the economy. So government policies have only short term effectiveness compared to long-run.