Question

(PARTB.

Suppose now producers (firms) receive news that future total factor productivity

will be

high

. The monetary authority targets the interest rate to the long run

equilibrium le

vel, and uses money supply to keep the interest rate at the target.

What will happen to the labor employment, real wage, output, consumption,

investment, average labor productivity, and money supply? Explain the reasons of

the direction of change for each

of the variables, and when necessary, use graphs

to help your explanation.)

PARET D. Suppose the economy finds itself in the situation described in part (b), and th

e

government desires to restore output to the long run equilibrium level by fiscal

policy (government purchases). The monetary authority targets the interest rate at

the long run equilibrium level and uses money supply to keep the interest rate at

that tar

get. Should the government increase or decrease its purchases of goods and

services? Describe the open market operation needed for keeping the interest rate

at target. How do consumption and investment compare to their respective levels

in part (c)?

Answer 1

Part B:

Considering that the economy is operating at the long run equilibrium, the increase in total factor productivity will increase the aggregate supply in the economy shifting the AS curve from AS1 to AS2. As a result the prices will fall in the short run, the interest rate will fall in the short run. To peg the interest rate at the initial long run level, the monetary authority must increase the money supply in the economy such that the Aggregate demand in the economy goes up and the AD curve shifts from AD1 to AD2 auch that a new long run equilibrium is attained at E3 where the interest rate and price level are as before while the potential output in the economy has increased, employment will be fully employed as before, average labor productivity increases. NEW LRAS is now shifted to the right altogether.

Part D :

The government should increase its purchase to be able to shift the aggregate demand curve to the right such that the prices rise after falling due to increased Aggregate supply consequent to increased factor productivity. To target the interest rate the open market operation needed must be such that the central bank buys securities and inject money supply in the economy. The consumption and investment will both be increased in the new equilibrium since the LRAS has increased all together. The potential level of output has increased in the economy.

** info from part c not available.