Question

In March 2018, the Federal Reserve Bank officials met and decided to increase the interest slightly (a quarter of one percent) and have hinted that there will be two or more interest hikes in 2018. The reason for these hikes is to prevent the economy from overheating as unemployment continues to drop. Using AD-AS model, show what could happen to the economy if the Fed hiked interest rate when the economy is close to full employment.

Answer 1

An increase in interest rate will decrease investment demand, and the portion of consumption demand funded by borrowing. It will lower aggregate demand, shifting AD curve leftward, leading to lower price level and lower real GDP. Since currently the economy is close to full employment, a fall in AD means the recessionary gap will increase.

In following graph, long run equilibrium is at point A where AD0, short run aggregate supply (SRAS0) and long run aggregate supply (LRAS0) intersect with price level P0 and potential GDP Y0. Currently, economy is at point B where aggregate demand is lower at AD1, intersecting SRAS0 with lower price level P1 and lower real GDP Y1, so the recessionary gap is equal to (Y0 - Y1). A fall in investment and consumption caused by higher interest rate will further lower aggregate demand, shifting AD1 leftward to AD2, intersecting SRAS0 at point C where price level is further lower at P2, and real GDP is further lower at Y2, so recessionary gap is higher at (Y0 - Y2).