Question

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. A. What happens to the aggregate demand curve?
B. What happens to the level of output and the price level in the short run and in the long run?
C. In light of your answer to part (b), what happens to unemployment in the short run and in the long runaccording to Okun’s law?

D. What happens to the real interest rate in the short run and in the long run? (Hint: Use the model of the real interest rate in Chapter 3 to see what happens when output changes.)

Answer 1

A. The aggregate demand curve will shift down. The quantity equation MV = PY, states that a reduction in money M results to a proportionate fall in nominal output PY (assuming the velocity of money is constant) thus the aggregate demand curve shifts down towards the left

B. In the short run, prices remains constant but the output would be decreased by 5% because the aggregate supply is perfectly elastic.

In the long run, price and output will fall because the supply is elastic in long run thus change in aggregate demand curve will increase price and output will eventually decrease.

　

C. In the short run as per Okun's law the unemployment would rise by 2.5% because real GDP fall by 2%. It is computed as:

% Change in Real GDP = 3.5% - 2 * Change in rate of Unemployment

In the long run there will be no change in unemployment because the output as well as unemployment would return to their original levels.

　

D. In short run when income falls, savings also falls thus there will be a rise in real interest rate. In long run it return to it's natural level.