3. The graph below shows the US economy in long run equilibrium with a spending

Question

3. The graph below shows the US economy in long run equilibrium with a spending growth of 4 percent, a 2 percent inflation rate, and a 2 percent real GDP growth Step 1: Suppose the Fed permanently increases money supply growth by 3 percent. Using the copy tool, show the short run effect this would have by shifting and labeling the appropriate curve(s). Plot the new short run equilibrium using the double drop line tool and label it Equilibrium 2 Step 2: Show how the economy will adjust in the long run by shifting and labeling the appropriate curve(s). Plot the new long run equilibrium and label it Equilibrium 3 Coordinates: (7.75, 1.50) SRAS 1 - RAS 2 -Agg Demand 1 -Agg Demand 2 Solow Gr Curve -Equilibrium 1 -Equilibrium 2 Equilibrium 3 Unselected Real GDP growth rate

Explanation / Answer

It has been given that the initial equilibrium level (E1), inflation rate is 2% and the real GDP growth rate is also 2%.

Short Run:
When money supply increases by 3%, the interest rate falls which reduces the cost of borrowing.
This increases investment spending (I) and in turn raises consumer spending (C).
The components of aggregate demand (AD) are as follows:
AD= C+I+G+NX where C: Consumption,
I: Investment,
G: Government Spending and
NX: Net Exports.
Here with an increase in I and C, the AD rises and the AD curve shifts rightward from AD1 to AD2. As a result, in the short run both the price level and real GDP growth level rises.
There is a new short run equilibrium at E2 where the price level is 4% (P2) and the GDP growth rate is 3.5% (Y2)

Long Run:
It is important to remember that the potential level of real GDP growth in the given example is at 2%.
This means that even if GDP growth rate does rise over and above the potential real GDP growth rate (Y*) in the short run, there is an adjustment in the long run such that the real GDP growth rate comes back to its potential level.
When real GDP growth rate rises above 2%, there is an increase in nominal wages in the economy which raises the cost of production.
As a result, the short run aggregate supply (SRAS) curve will shift leftward from SRAS1 to SRAS2 as real GDP in the economy declines.
Thus, there is a new and third equilibrium at E3 which is a long run equilibrium.
At that level, inflation rate rises to 5% (P3) and the real GDP growth rate falls to 2%.

Therefore, in conclusion an increase in money supply leads to an increase in the price level and real GDP in the short run, but the same level of output at higher price level in the long run.

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