Question

1. Using the Aggregate Demand (AD) model diagram, illustrate what happens to the equilibrium level of aggregate output when firms start to feel more optimistic about the future and increase their investment. (Hint: What happens to the IS curve?) Make sure you properly label all the axes and curves. Will this lead more likely to an expansion or recession?

2. Using the Aggregate Demand (AD) model diagram, illustrate what happens to the equilibrium level of aggregate output when the Federal Reserve (Fed) engages in an autonomous easing of monetary policy. (Hint: What happens to the MP curve?) Make sure you properly label all the axes and curves. Would the Fed be more likely to engage in an autonomous easing of monetary policy during an expansion or recession?

Answer 1

In each of the following IS-LM graphs, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and initial output Y0. In each of the following AD-AS graphs, AD0 and AS0 are aggregate demand and (short run) aggregate supply curves intersecting at point A with initial price level P0 and initial output Y0.

(1)

When firms increase investment, IS curve shifts rightward, increasing both interest rate and output. Higher investment increases aggregate demand, shifting AD curve right and increasing both price level and real GDP (output), causing an expansion.

In following graphs, IS0 shifts right to IS1, intersecting LM0 at point B with higher interest rate r0 and higher output Y0. In AD-AS graph, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP (output) Y1.

(2)

When Fed eases monetary policy, money supply rises, shifting LM curve rightward, decreasing interest rate and increasing output. Higher money supply increases aggregate demand, shifting AD curve right and increasing both price level and real GDP (output). Fed will conduct an easier monetary policy during a recession, to boost aggregate demand.

In following graphs, LM0 shifts right to LM1, intersecting IS0 at point B with lower interest rate r0 and higher output Y0. In AD-AS graph, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP (output) Y1.