Question

If the Fed wishes to stimulate the economy, what tools it has at its disposal? Discuss two of these tools and with the help of an AD-AS model, demonstrate the effect on output and price-level.

Answer 1

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply. It is based on the theory of John Maynard Keynes presented in his work The General Theory of Employment, Interest, and Money. It is one of the primary simplified representations in the modern field of macroeconomics, and is used by a broad array of economists, from libertarian, Monetarist supporters of laissez-faire, such as Milton Friedman, to Post-Keynesiansupporters of economic interventionism, such as Joan Robinson.

The conventional "aggregate supply and demand" model is, in actuality, a Keynesian visualization that has come to be a widely accepted image of the theory. The Classical supply and demand model, which is largely based on Say's law—that supply creates its own demand—depicts the aggregate supply curve as being vertical at all times (not just in the long-run)

The AD/AS model is used to illustrate the Keynesian model of the business cycle. Movements of the two curves can be used to predict the effects that various exogenousevents will have on two variables: real GDPand the price level. Furthermore, the model can be incorporated as a component in any of a variety of dynamic models (models of how variables like the price level and others evolve over time). The AD–AS model can be related to the Phillips curve model of wage or price inflation and unemployment. A special case is a horizontal AS curve which means the price level is constant. The AD curve represents the locus of equilibria in the IS–LM model. The two models produce the same results with a constant price level.