Question

1. Suppose the economy is initially at the medium-run equilibrium. Now FED decides to increase money supply to stimulate the economy. Please answer the following questions to go through the impacts of this expansionary monetary policy on macro-economy both in the short run and medium run:

(1) Draw the AS-AD graph. Mark the original equilibrium position before this monetary policy. Explain the shift of either the AS or AD curve and carefully describe how the economy adjusts from the short-run equilibrium to the medium-run equilibrium.

(2) In the new medium-run equilibrium, will the interest rate increase or decrease or go back to its previous level before the monetary policy? What about the investment level? Explain using either AS-AD or IS-LM framework or both.

Answer 1

1)

Increase in money supply will create shortage of money demand at intial equilibrium interest rate.To eliminate the shortage, interest rate keep Decrease,till money market reaches equilibrium,where money demand equal to money supply.

Decrease in interest rate , increase investment and thus increase aggregate expenditure and aggregate demand and AD curve shift right.

The Equilibrium GDP increase ( goes above full employment GDP) and Price level increases in short run.

Because short run equilibrium GDP is above full employment gdp,so economy is in inflationary gap and rising prices.

Rising price lead to workers demand higher wages,which lead increase in production cost and thus AS curve shift left.

And economy again reach full employment equilibrium GDP in medium run.

2)

At new medium run equilibrium price level is higher ,while equilibrium GDP is same .

Higehr price level Decrease real Money supply, resulting same real money supply as before.

Decrease in money supply also increase interest rate.and will equal to initial medium run equilibrium interest rate.

Increase in interest to intial level lead to investment to decrease to intial level.( Same as initial medium run equilibrium investment)