Question

Suppose the economy is initially in long-run equilibrium and the Fed adopts a looser monetary policy and raises its long-run target for the inflation rate.

a. Explain how this change in monetary policy will affect the AD curve.

b. Use your result for part a along with an AD-AS diagram to illustrate and explain what will happen to output and inflation in both the short run and the long run.

Answer 1

Ans.
a) In short run, a loose monetary policy will increase the money supply which at given money demand will decrease the interest rate. This will lead to decrease in cost of borrowing inducing investment and consumption spending. This decrease in interest rate will also lead to increase in net capital outflow which will lead to depreciation of domestic currency increasing net exports because exports become cheaper and imports become expensive. This will lead to increase in aggregate demand for goods and services shifting the aggregate demand curve to right from AD to AD'.

b) Increase in aggregate demand at given level of aggregate supply will lead to increase in price level from P to P' and increase in output from full employment level Y to Y'.

In long run, increase in price level will make workers to demand more wages increasing cost of production decreasing aggregate supply shifting aggregate supply curve left from AS to AS'. This will lead to increase in price level from P' to P" and output will decrease back to full employment level Y.

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