Question

1) AS-AD analysis: As part of the Y2K problem a several years ago, it was feared that bank computers and ATMs might malfunction on January 1, 2000. The Federal Reserve was actually quite concerned about this. Analyze this situation in terms of aggregate demand and aggregate supply curves from chapter 9 (based on the quantity theory of demand where price is fixed in the short run but flexible in the long run). Regard this as a fall in money velocity that is temporary, just affecting the short run but returning to normal in the long run.

a) Which should the Federal Reserve worry about: a possible recession or excessive inflation?

b) Discuss what monetary policy actions you would suggest to prevent any such problems.

Answer 1

(a)

A fall in velocity of money will increase the demand for money, shifting money demand curve to right, increasing interest rate. As interest rate rises, investment falls, reducing aggregate demand which lowers price level and real GDP, causing a recession.

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 with long-run equilibrium price level P0 and long-run equilibrium real GDP (= potential GDP) Y0. As aggregate demand falls, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap of (Y0 - Y1).

(b)

To increase aggregate demand, Fed should increase money supply by reducing required reserve ratio, reducing discount rate or buying securities in open market. Higher money supply will lower interest rate, boosting investment and consumption and increasing aggregate demand.