Question

Using the aggregate demand-aggregate supply diagram, briefly explain

1. the Short-Run and Long-Run effects (on output and prices) of an Increase in money supply.

2. the Short-Rin and Long-Run effects (on output and prices) of a negative demand shock

3. how stabilizing monetary policy deal with an adverse supply shock.

Course relate to Macroeconomics ch. 10 Introduction to Economic Fluctuations

Answer 1

In each 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 initial long-run equilibrium price level P0 and initial equilibrium real GDP (= Potential GDP) Y0.

(1)

Increase in money supply decreases interest rate, which increases investment demand, in turn increasing aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an expansionary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating expansionary gap.

In following graph, when investement rises, AD curve will shift rightward from AD0 to 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 long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, eliminating expansionary gap.

(2)

A negative demand shock decreases aggregate demand. AD curve will shift to left, decreasing price level and decreasing real GDP, causing a recessionary gap in short run. In the long run, lower price level decreases input costs, so firms increase production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original real GDP and eliminating recessionary gap.

In following graph, when a negative demand shock arises, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap being equal to (Y0 - Y1) in short run. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0, eliminating recessionary gap.

(3)

An adverse supply shock decreases short run aggregate supply. SRAS curve will shift left, increasing price level and decreasing real GDP, causing stagflation in short run. In the long run, a stabilizing monetary policy will increase money supply (to lower interest rate and boost investment), thus increasing aggregate demand. AD shifts rightward, intersecting new SRAS curve at further higher price level but restoring original real GDP to potential GDP.

In following graph, an adverse supply shock causes SRAS0 shift leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1. In long run, AD0 shifts right to AD1, intersecting SRAS1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.