Question

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money (V) is constant.

a. What happens to the aggregate demand (AD) curve?

The AD curve shifts

b. What happens to output and the price level in the short run and long run? Give precise numerical answers.

In the short run, the price level decreases by

c. In the short run, output decreases by

d. In the long run, output will ultimately decrease by

e. In the long run, the price level will decrease by

f. Consider your answers to the above questions. What happens to unemployment in the short run and in the long run, according to Okun’s law? Again, give a precise numerical answer.

In the short run, unemployment increases by

g. In the long run, unemployment increases by

Answer 1

Suppose the Fed reduces the money supply by 5 percent. And velocity of money (V) is constant.

(a) If the Fed reduces the money supply ,the aggregate demand curve shifts down. Because we know, MV=PY ,which tells us that a decrease in money M leads to a proportionate decrease in in nominal output PY (as V is constant). For any given price level P ,the output level Y is lower .And for any given output level Y, the price level P is lower.

(b) In the short run we know that the price level is fixed and the aggregate supply curve is flat.In the short run , output falls but the price level doesn't change. In the long run prices are flexible and as prices fall over time , economy returns to full employment level.

We know , M/ M + V/V = P/P + Y/Y

We know that in the short run ,the price level is fixed. This implies that the percentage change in prices is zero and thus M/M =Y/Y . Thus in the short run a 5 percent reduction in money supply leads to a 5 percent decrease in output.

In the long run, we know that prices are flexible and the economy returns to its natural rate of output. This implies in the long run ,the percentage change in output is zero and thus M/M = P/P .Thus in the long run a 5 percent reduction in money supply leads to 5 percent reduction in the price level.

In the short run price level decreases by 0 percent.

(c) In the short run output decreases by 5 percent.

(d) In the long run , output will ultimately came back to natural rate , so 0 percent change in output.

(e) In the long run the price level decrease by 5 percent.

(f) Okun's law refers to the negative relationship between unemployment and real GDP.

Okun's Law: Y/Y= 3.5% - 2( in unemployment).

Output moves in the opposite direction from unemployment with a ratio of 2 to 1. In the short run , when output falls, unemployment rises.If V is constant , in the short run Y falls by 5% , so unemployment increases by 2.5%. In the long run , both output and unemployment return to their natural level , so there is no long run change unemployment.

(g) In the long run , unemployment increases by 0 percent , because return to the natural level.