Question

Assume the economy is operating in short-run equilibrium at potential GDP. In writing and in a graph, explain the short-run and long-run effects of each of the events below on the equilibrium price level and RGDP. Assume the economy self-corrects.

The Federal Reserve, the central bank of the United States, increases the money supply, lowering interest rates.

Due to better than expected weather, crop yields in the United States increase.

Answer 1

In each graph, AD0, SRAS0 and LRAS0 are initial aggregate demand, short run aggregate supply and long run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (= potential GDP) Y0.

(1) An expansionary monetary policy increases money supply, which will increase aggregate demand and shift AD curve toward right, increasing both price level and real GDP which gives rise to an inflationary gap in short run. In the long run, higher price level will increase cost of input, so firms will decrease output and aggregate supply will reduce, shifting SRAS to left, and new long run equilibrium is at a further higher price but real GDP will be equal to potential GDP, eliminating short run inflationary gap. In following graph, as AD0 shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, causing inflationary gap equal to (Y1 - Y0) in short run. In long run, as SRAS0 shifts left to SRAS1, it intersects AD1 & LRAS0 at point C with still higher price P2 and real GDP is restored to potential GDP of Y0, eliminating the short run inflationary gap.

(2) When crop yield rises, aggregate supply rises, shifting the short run AS curve rightward, decreasing price level and increasing output. However, in the long run as price and wage expectations adjust, aggregate demand falls, shifting AD curve leftward until equilibrium is restored at potential GDP level but at a further lower price level. In following graph, as crop yield rises, SRS0 shifts right to SRAS1, intersecting AD0 at point B with lower price level P1 and higher output Y1. In long run, as AD0 shifts left to AD1, it intersects SRAS1 at point C with real GDP being restored to Y0 but price level being further lower at P2.