Question

Suppose the Fed increases interest rates in the country.

a. Which curve shifts first and why? Graph the Goods and Services market, including the shift.

b. What happened to the price level and RGDP in the short-run? What type of business cycle did this cause?

c. Over time, what will eventually happen to resource costs given the above scenario?

d. From your answer in part c, what subsequent shift will occur? Indicate this shift using your graph given above. What is the ultimate long-run effect on the Deflator and RGDP?

Answer 1

Refer to the below figure: X-axis represents the Real GDP and Y- axis represents the price level. Let’s assume initially the economy is at its long-run equilibrium at point A, where the long-run aggregate supply curve (LRAS), the short-run aggregate supply curve (SRAS1) and the aggregate demand curve (AD1) intersects. The equilibrium price level is P1 and equilibrium level out real GDP is equal to the full employment level Y*.

a. If Fed increases interest rate, it means borrowings become relatively expensive. In response to this, the households and business firms reduce consumption and investment spending. A fall in aggregate spending cause the aggregate demand curve to shift downwards from AD1 to AD2.

b. At the given price level, the aggregate demand falls short of the aggregate output available in the economy. This excess aggregate supply puts a downward pressure on the price level by making it fall from P1 to P2. In response to lack of demand and to avoid future losses due to lower price level, firms and business owners decide to cut down on production leading to a fall in the Real GDP from Y* to Y1. Hence, aggregate income and employment level falls leading to higher unemployment rates. The economy moves to a short-run equilibrium at point B.

Since, actual real GDP falls short of the potential real GDP (Y1<Y*), the economy experiences a Contractionary gap equal to Y1 – Y*. This means the economy moves into the recessionary phase of the business cycle in the short-run.

c. During short-run, the input costs such as wages and raw material cost remain sticky, but overtime they become flexible. In the long-run all the prices fall too i.e. wages and raw material cost experience a declining trend. This reduction in the cost of production boosts the producer’s confidence as more profits can be generated and induces them to hire more labor and increase production levels.

d. Sine greater profits are expected with low cost of production, it causes the short-run aggregate supply curve to shift rightwards from SRAS1 to SRAS2. As a result, the economy moves back to its new long-run equilibrium level at point C where all the 3 curves i.e. LRAS, SRAS2 and AD2 intersects. The price level further drops down from P2 to P3 and the real GDP increase and stabilizes back to its potential level Y*. A fall in price means lower price inflation thus a lower deflator or one could say an increase in real GDP leads to a fall in the value of the deflator. [Because the Deflator = (Nominal GDP/Real GDP) * 100]