Question

1. Draw two separate graphs that show the “do nothing” or classical approach and the active monetary policy or Keynesian approach in the case of an aggregate demand shock in the AS-AD framework. Briefly explain the steps involved in the Fed’s monetary response.

Answer 1

Ans

In case of do nothing see fig 1 Here AD meets SRAS at A so that actual output is less than full employment level shown by LRAS. This is due to AD shock. Now classicals believe due to greater unemployment at A wages will decline. This will shift shortrun Aggregate supply to SRAS1 and new equilbrium is at B where there is full employment output.

2 Again shortrun equilbrium is at A. However Keynesians assume wages don't fall due to rigidity. So we have to use active monetary to achieve potential output. To achieve this end fed will use expansionary monetary policy which will shift AD to AD1 and at new equilbrium B full employment output is restored.

Fed will use either open market purchase of securities or decline discount rate or reduce reserve requirement This will increase funds available to banks and interbank rate will fall. Since cost of finance to banks fall they will decrease their own lending rates. Lower interest rates stimulate investment and consumption thus shift AD to AD1