What happens in the aggregate economy (ADAS model) as a result of the increase in money supply and reduction in interest rates?

The aggregate demand curve shifts to the left.

The short-run aggregate supply curve shifts to the right.

The short-run aggregate supply curve shifts to the left.

The aggregate demand curve shifts to the right.

Expert Solution

According to the AD AS model, the aggregate economy is affected when the money supply increases and interest rate reduces. With an increase in the money supply, and a decrease in the interest rate, the cost of borrowing becomes lower and as a result, investments increase. The overall quantity of aggregate demanded increases at a given price level. It is explained with the help of a graph below:

It is observed that there is an increase in money supply from S₁ to S₂ and a decrease in the interest rate from r₁ to r₂. The quantity of money per period has increased from M to M'. With an increase in the quantity of money and a reduction in the interest rate, the cost of borrowing reduces and citizens invest more. The investments increase, the quantity of output also increases from Y₁ to Y₂ and the aggregate money demanded at a given price level increases from AD₁ to AD₂ as shown above. Thus, there is a rightward shift in the aggregate demand curve. The correct option is:

'The aggregate demand curve shifts to the right.'

On the other hand,

'The aggregate demand curve shifts to the left.' is a contrary statement as the aggregate demand increases and shifts to the right. So, it is incorrect.

'The short-run aggregate supply curve shifts to the right.' is incorrect because as provided in the graph of the problem, the supply curve is a perfectly inelastic curve, which is only possible in the long run. Hence, long-run effects will be taken into account.

'The short-run aggregate supply curve shifts to the left.' is incorrect because when money supply increases, the supply curve shifts to the right and not to the left.

Rahul Sunny answered 2 years ago

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