Question

Suppose the economy is initially in long-run equilibrium and the Reserve Bank adopts
a looser monetary policy and raises its long-run target for the inflation rate.
a) Explain how this change in monetary policy will affect the aggregate demand
(AD) curve.
b) Use your result in part (a) along with an aggregate demand-aggregate supply
(AD-AS) diagram to illustrate and explain what will happen to output and
inflation in both the short-run and the long-run.

Answer 1

a) As Reserve Bank adopted looser monetary polict, it will shift LM curve to its left from LM to LM1 which will raise rate of interest from "i" to "i1" and reduce output level from "Y" to "Y1".

Reduction in money supply will reduce the money holding with people and tends to reduce their willingness to pay for goods and reduce aggregate demand in the economy for all goods in short run. A fall in aggregate demand will shift aggregate demand curve to its left from AD to AD1 while aggregate supply remains the same

b) In long run, producers will tend to reduce their production to avoid inventories because there is less demand. It will shift aggregate supply curve to its left from S to S1 which will reduce output level further from Y1 to Y2 and raise price from P1 to P2. Only if shift in aggregate supply is more than aggregate demand, it will cover Reserve Bank wish to raise inflation rate in long run.