Question

1.  Use the AD-AS model to answer the following questions. Suppose that an economy is initially in its long-run equilibrium.

 

(a) Suppose now that the interest rate rises sharply.

 

1. Explain what will happen to consumption and investment.

2. Graphically and verbally explain how the increase in the interest rate will change AD, LRAS, and/or SRAS and thus will change the output level and the price level in the short run.

 

(b) Suppose now that after the increase in the interest rate, the Fed is deciding between implementing its expansionary monetary policy and letting the market handle.

 

1. Graphically and verbally explain how the economy restores its long-run equi- librium if the Fed does not intervene in the economy and just lets the market handle.

2. Graphically and verbally explain how the economy restores its long-run equi- librium if the Fed actively and quickly implements its expansionary monetary policy.

Answer 1

Answer a part 1) AD refers to aggregate demand which is the amount of total spending on goods and services in an economy and it contains the following components- consumption, investment, government spending and Net Exports.

while AS refers to aggregate supply which is the total quantity of output, the firms in an economy will produce and offer for sale which is also known as GDP.

Now, is there is an increase in interest rates which may happen due to additional demand for money, the firms and households will borrow less money and will have less money to invest thus, both consumption and investment falls.

2) an increase in interest rates will change AD,SRAS and the output level as explained in the following diagram

The original price was P1 and output Y1 and aggregate demand curve is AD1

With increase in interest and decrease in consumption and investment,the prices will fall leading to decrease in GDP and so the AD curve will shift towards left to AD2.and prices fall to P2.

b)

1-If fed does not intervene in the long run, the economy will handle it itself and as the supply will be fixed and other factors such as technology, labour, innovation will change which will adjust the equilibrium position to P3,Y3.

If price gets lower,the demand will be high which will push the price further and if the price is too high, the demand will be lower which will bring the prices down and they will be at equilibrium at E and the GDP will be stagnant.

2- If the fed intervenes,

the supply will not be a vertical fixed line and will change with the fed's expansionary monetary policy where it pumps more money into the market and also decreases the interest rates and bank will have more cash to lend the firms and households which will increase the demand and investments thereby pushing the AD curve to right at AD2 and increase the GDP.