Question

Predict the impact an unexpected decrease in the money supply would have on the following variables in the short run and in the long run. a. The inflation rate b. The unemployment rate c. Real output d. Real wages

Answer 1

A decrease in money supply increases interest rate which decreases investment and the portion of consumption demand funded by borrowing, and thus decreases aggregate demand which shifts the AD curve to left. It decreases price level and real GDP in short run, giving rise to a recessionary gap in short run. So, in short run, inflation rate falls, unemployment rate rises, real output falls and real wages real wage increases. In the long run, lower price level reduces cost of inputs which decreases the production cost, so firms increase output. Aggregate supply rises, shifting the short run aggregate supply curve to right, and the process continues until long run equilibrium is achieved at potential GDP level but at a further lower price level. So, in long run, inflation rate falls, unemployment rate returns to natural rate of unemployment, real output returns to natural rate of output (potential GDP) and real wages increase.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with long-run equilibrium price level P0 and output (real GDP = potential GDP) Y0. As business outlook declines, investment falls and AD decreases, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower output Y1, giving rise to a recessionary gap equal to (Y0 - Y1) in short run. In the long run, aggregate supply increases, shifting SRAS0 to right to SRAS1 where it intersects AD1 at point C with a still lower price level P1, but real GDP is restored at potential GDP of Y0, eliminating the recessionary gap.