Question

During the depression, the U.S central bank, the Federal Reserve, enacted policies that increased the money supply by 6% .

1). what happens to the level of output and the price level in the short run and in the long run.

2). Assume that the velocity is constant, what is the percentage change of output and price level in the short run and long run (Hint: use quantity theory of money).

3). What happens to unemployment in the short run and long run? (Hint: Okun’s law can be summaries in the following equation: %∆in unemployment rate =

−(%∆in real GDP −4%))

4). What happens to the real interest rate in the short run and long run? (Hint: Use the model of real interest rate in Chapter 3, to see what happens when output changes)

Answer 1

We are given that money supply is increased in the economy.

1) This will stimulate spending and so, as a result of interest rate reduction, aggregate spending will rise and AD shifts outwards. This will increase the level of prices and output in the short run. Because the economy was in Depression (recessionary gap) the economy will slowly reach its long run equilibrium level but the transition will take time. In the long run price level will be higher and output will reach its full employment level.

2). Assume that the velocity is constant. We realize that

% change in price + % change in GDP = % change in money supply + % change in velocity

% change in price + % change in GDP = 6% + 0% = 6%

Hence a 6% change of output and price level in the short run and long run will be observed.

3). In the short run there will be an increase in the level of prices so unemployment rate will fall. Okun’s law suggests that a one-percent increase in the growth rate of output towards its potential level, will decrease the unemployment rate by 0.5 percent. Here real GDP will rise by 6% if prices are held constant. Then unemployment rate will fall by 3%.

4). Real interest rate will fall because inflation is increased in the short run. This is also true because the money supply is increased and this puts a downward pressure on the interest rate to fall as banks reserves swell up. In the long run real interest rate will return to its long run value because nominal interest rate will increase parallel to the rate of inflation.