Question

Suppose the economy is initially at the medium-run equilibrium. Suppose because of less competition the mark-up goes up. Please answer the following questions to go through the impacts of this on macro-economy both in the short run and medium run:

Draw the AS-AD graph. Mark the original equilibrium position before this monetary policy. Explain the shift of either the AS or AD curve and describe carefully how the economy adjusts from the short-run equilibrium to the medium-run equilibrium.

In the new medium-run equilibrium, will the interest rate increase or decrease or go back to its previous level before the monetary policy? What about the investment level? Explain using either AS-AD or IS-LM framework or both.

Answer 1

The initial equilibrium in the AD-AS and IS_LM model occurs at point E1. A decrease in competition and increase in mark up of the firm will reduce the level of aggregate supply in the economy shifting the SRAS curve leftwards to SRAS' and thus new short run equilibrium shifts from point E1 to point E2 where prices have increased to P2 and level of Real GDp has decreased to Y2 in the short run. This causes recessionary gap and increases unemployment rate which reduces real wage rate and this decreases cost of production. This reduction in the cost of production will shift the SRAS' curve rightwards to SRAS and initial medium run equilibrium is restored at point E1.

In the IS-LM framework, increase in price level in short run will reduce real money supply and LM shifts leftwards to LM' and at new equilibrium point E2, the rate of interest has increased and this reduces investment level in short run. In the medium run, since economy id back to E1, the rate of interest will fall back to initial level.