Question

2-) The Government observes a significant amount of unemployment in the economy. Some argue that the government should stimulate the economy in order to decrease the unemployment level using monetary policy.

a) Using the theory of liquidity preference, show the effects of expansionary monetary policy. What will happen to the interest rate? What will happen to the aggregate demand as a result? You must explain why we observe this relationship.

b) Draw the new short-run equilibrium of the economy. What happened to the price level, output and the unemployment level in the new short-run equilibrium?

c) How will the economy adjust in the long-run? Explain the transition and show it on a graph. What will happen to the price level, output and unemployment?

d) Show how the same economy will adjust in the short-run and the long-run using a Phillips curve this time. Use the same labels you used for the initial, the short-run and the long-run equilibrium that you used in part c).

e) Would you advise the government to undertake this policy considering your answers to part c) and d)? Why? What will be happening to the policy options in the long-run? Explain by talking about the trade-off options between unemployment and inflation.

Answer 1

A. An expansionary monetary policy will shift the supply of money (MS) to the right. As a result the rate of interest will come down. It encourages the investors to increase their investment which creates more income with the help of multiplier. Production, employment and output increase in the economy. So that consumption or aggregate demand in the economy will increase. We can understand that an increase in the money supply through expansionary monetary policy will finally lead to an increase in the aggregate demand. There two are positively related.

B. An increase in the aggregate demand shift to the right( AD to AD1) and new equilibrium point is established at B where price is P1 and output is Y1( both are increasing). The unemployment will fall in the short run. This is shown in the below figure.

C. Suppose an increase in the price level promotes firms to produce more as a result AS shifts to the right and output increase Y2 and price comes to its normal level. In the long-run in order to maintain equilibrium AS shifts to the left ( because of the fall in the price level). So that price rises further and output cones to its original level in the long-run. The unemployment will increase at this point compared to initial levels. This is shown in the above figure.

D. In the short run Philips curve, initially unemployment falls due to monetary expansion. As a result people supply more labour because they are temporary money illusion ( people have experienced price stability at A). when they realised it come to its normal position. This process continues. By joining A, B, and C, we will get long run philips curve. This is shown in the below graph

E. The government policy will give short run benefits only. There is no permanent trade off between inflation and unemployment in the expectation augmented Phillips curve. Here the government would attempt to reduce unemployment by monetary expansion which will reduce unemployment in the short run which raise the price level. But in the long-run unemployment come to its natural level butOne the price rises (inflation) we cannot pull down the inflation in its original level. So government should adopt a policy which have only a temporary effects in the economy. The reason is that in the long-run there is no trade off between inflation and unemployment.