Question

1. a. On a graph, show the effect of a drop in velocity due to “animal spirits” in the short run if wages are “sticky.”

b. Now show what will happen in the long run if nothing else is done. What will happen to nominal wages?

c. If the central bank wants to prevent the short-run effects in part a, what could they do?

Answer 1

1. In the short run when prices are sticky, the economy moves from the initial equilibrium, point A, to the short-run equilibrium, point B. The drop in aggregate demand reduces the output of the economy below the natural rate to Q'.

b) Over time, the low level of aggregate demand causes prices and wages to fall. As prices fall (from P1 to P2), output gradually rises until it reaches the natural-rate level of output at point Q.

c) If the central bank wants to prevent the short-run effects in part a by keeping output and employment at their natural-rate levels, it must increase aggregate demand to offset the decrease in velocity. Increasing the money supply, it can shift the aggregate demand curve upward, restoring the economy to its original equilibrium at point A. Both the price level and output would then remain constant. If the central bank wants to keep prices stable, it would want to avoid the long-run adjustment to a lower price level at point B in the figure above. Therefore, it should increase the money supply and shift the aggregate demand curve upward, restoring the original equilibrium at point A.