Question

11. Suppose that the economy is in a long run equilibrium. a.) Draw an Aggregate Supply - Aggregate Demand graph of the economy. Label the equilibrium point “E1 ". The Fed conducts an open market sale of bonds. On your graph, show the movement of the appropriate curves in the short-run AND long-run. Label the short run equilibrium point “E2” and label the long run equilibrium point “E3” b.) Draw an Aggregate Supply - Aggregate Demand graph of the economy. Label the equilibrium point “E1 ". The Fed conducts an open market purchase of bonds. On your graph, show the movement of the appropriate curves in the short-run AND long-run. Label the short run equilibrium point “E2” and label the long run equilibrium point “E3”

Answer 1

In each of the following graphs, initial long-run equilibrium is at point E1 where AD1 (aggregate demand), LRAS1 (long-run aggregate supply) and SRAS1 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P1 and real GDP (= Potential GDP) Y1.

(a)

An open market sale of bonds decreases money supply, which increases interest rate. Higher interest rate decreases investment, lowering aggregate demand. AD curve shifts leftward, decreasing price level and real GDP, causing a recessionary gap in short run. In long run, lower price level reduces production cost, so firms increase output. Aggregate supply increases, and SRAS curve shifts rightward, further decreasing price level but restoring real GDP to potential GDP level.

In following graph, when money supply decreases, AD curve will shift leftward from AD1 to AD2, intersecting SRAS1 at point E2 with lower price level P2 and lower real GDP Y2, with recessionary gap being equal to (Y1 - Y2) in short run. In long run, SRAS1 shifts right to SRAS2, intersecting AD2 at point E3 with further lower price level P3 and restoring real GDP to potential GDP level Y1, removing the short-run recessionary gap.

(b)

An open market purchase of bonds increases money supply, which decreases interest rate. Lower interest rate increases investment, increasing aggregate demand. AD curve shifts rightward, increasing price level and real GDP, causing an inflationary gap in short run. In long run, higher price level increases production cost, so firms decrease output. Aggregate supply decreases, and SRAS curve shifts leftward, further increasing price level but restoring real GDP to potential GDP level.

In following graph, when money supply increases, AD curve will shift rightward from AD1 to AD2, intersecting SRAS1 at point E2 with higher price level P2 and higher real GDP Y2, with inflationary gap being equal to (Y2 - Y1) in short run. In long run, SRAS1 shifts left to SRAS2, intersecting AD2 at point E3 with further higher price level P3 and restoring real GDP to potential GDP level Y1, removing the short-run inflationary gap.