Question

. Analyze the following statement, and show what would happen in the long run if such advice were followed by the Fed: "The increase in the stock market has increased people's wealth. As a result, their consumption has increased, increasing aggregate demand and output. So the Fed needs to increase the money supply, since with higher income, people's demand for real money balances will be higher."

Answer 1

The statement is incorrect.

Increase in stock market will increase consumer wealth, increasing consumption and aggregate demand in short run. The AD curve will shift rightward, increasing both price level and real GDP in short run, causing an expansionary gap. To tame inflation, Fed needs to decrease money supply which will increase interest rate. At higher interest rate, investment demand will fall, lowering aggregate demand and shifting AD curve leftward until the long-run equilibrium is restored by eliminating the expansionary gap. If, instead, Fed increases money supply, it will decrease interest rate. At lower interest rate, investment demand will rise, increasing aggregate demand and shifting AD curve rightward, leading to an inflation spiral.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (= Potential GDP) Y0. When aggregate demand is higher in short run, AD0 curve will shift rightward AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with expansionary gap being equal to (Y1 - Y0) in short run. In the long run, if Fed increases money supply, AD1 will shift rightward to AD2, intersecting SRAS0 at point C with further higher price level P2 and further higher real GDP Y2, moving further away from long-run equilibrium condition in long run.