Question

The economy is in long-run macroeconomic equilibrium with an unemployment rate of 8% when the government passes a law requiring the central bank to use monetary policy to lower the unemployment rate to 3% and keep it there.

a) How could the central bank achieve this goal in the short run?

b) Does your answer depend on whether demand or supply shocks are the predominate problem faced by the nation? What might happen In the long run? Explain verbally and graphically.

Answer 1

Ans)

If the economy is in long-run macroeconomic equilibrium with an unemployment rate of 5%, then the long-run aggregate supply curve must be vertical at a real GDPthat is associated with a 5% unemployment rate. This long-run macroeconomic equilibrium isE1in the accompanying diagram. In the short run, the central bank can engage in an expansionary monetary policy to shift the aggregate demand curve to the right (fromAD1toAD2) and reduce the unemployment rate to 3%. Over time, will shift because real GDP exceeds potential output, the short-run aggregate supply will shift to the left (fromSRAS1toSRAS2). So to keep the unemployment rate at 3% inthe short run, the central bank would have to engage in continuous increases in themoney supply, shifting the aggregate demand curve to the right as the short-runaggregate supply curve shifts to the left, and the aggregate price level will go higherand higher. However, the central bank cannot keep the unemployment rate at 3% inthe long run, since, in the long run, money is neutral. In the long run, output willreturn to its potential level and the unemployment rate will return to 5%.