Question

Using a separate AS-AD diagram for each part, illustrate the following: a. Aggressive open market purchases assuming the economyis initiallyin a recessionary gap. b. Aggressive open market sales assuming the economy is initially in an inflationarygap. c. Aggressively lowering the Federal Funds rate assuming the economy is initially at potential output.

Answer 1

In each of the following graphs, long run equilibrium is at point A where aggregate demand (AD0), short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0) intersect with initial price level P0 and real GDP (potential GDP) Y0.

(a) When economy is initially in recessionary gap, real GDP is less than potential GDP because aggregate demand curve is AD1, which intersects SRAS0 at point B with lower price level P1 and lower real GDP Y1, the recessionary gap being (Y0 - Y1). An open market purchase will increase money supply which lowers interest rate, thus boosting investment demand to increase aggregate demand, and AD1 shifts rightward until it reaches AD0, bringing the economy back to original long run equilibrium level.

(b) When economy is initially in inflationary gap, real GDP is higher than potential GDP because aggregate demand curve is AD1, which intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, the inflationary gap being (Y1 - Y0). An open market sale will decrease money supply which raises interest rate, thus lowering investment demand to decrease aggregate demand, and AD1 shifts leftward until it reaches AD0, bringing the economy back to original long run equilibrium level.

(c) When economy is initially at point A, lowering the federal funds rate will increase money supply which lowers interest rate, thus boosting investment demand to increase aggregate demand, and AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, creating an inflationary gap equal to (Y1 - Y0) in short run.