Question

Explain the effect of the Fed's action that increases the quantity of money on the macroeconomic equilibrium in the short run. Use the aggregate supply{aggregate demand graph to illustrate the effect on real GDP and the price level. Explain the adjustment process that returns the economy to full employment (be precise in labeling the axes and curves).

Answer 1

Suppose the economy is initially in long run equilibrium at point A, producing the full employment output, To.

If the Fed increases the quantity of money, in the short run people will have more money to spend. Therefore, Consumption spending will increase. Also, increase in the money supply decreases the equilibrium interest rate. This will induce investment because cost of borrowing decreases. Therefore, in the short run, both Consumption and investment spending increase. As a result, aggregate demand increases. In the short run, AD curve shifts Rightward from AD1 to AD2. As a result, both equilibrium price level and real GDP increase from P1 to P2 and Yp to Y2 respectively. New short run equilibrium occurs at point 2.

Increase in the price level causes inflation, which decreases real value of wages. Therefore, workers will demand more wages and thus cost of production will increase. In the long run, this will decrease the aggregate supply, shifting the SRAS curve leftward from SRAS1 to SRAS2. SRAS will shift until the economy goes back to producing full employment level of output again. New long run equilibrium occurs at point 3. In the long run, equilibrium price level further increases to P3 and real GDP decreases from Y2 to Yp.