Question

2. [Monetary Policy] (a) Using the aggregate demand-aggregate supply model, explain and demonstrate graphically the short-run and long-run effects of a decrease in the money supply.

(b) Using the aggregate demand-aggregate supply model, explain and demonstrate graphically the short-run and long-run effects of a temporary negative supply shock.

Answer 1

a) When the money supply decreases,the interest rates rises which decreases investment spending and quantity of goods demanded so the AD curve shifts to the left and the economy moves to a new equilibrium position where the real GDP is below the potential level at a lower price level which will lead to fall in nominal wages and shift the SRAS curve to the right.

In the long run,the aggregate output returns to the potential level at a lower price level so a decrease in money policy would decrease output and price in the short run but only cause the price to decrease in the long run.

b) With the temporary negative supply shock,the short run aggregate supply curve will shift to the right which leads to an increase in the inflation rate and a fall in the output.

In the long run,as the aggregate demand curve is constant,the output and inflation rate will not fall and remain unchanged.