Assume that the short-run equilibrium output and price combination (Yeq,Peq) in
ID: 1193073 • Letter: A
Question
Assume that the short-run equilibrium output and price combination (Yeq,Peq) in a closed economy is characterized by the point where the aggregate demand curve AD intersects the short-run aggregate supply curve SRAS. Aggregate demand AD is determined by IS-LM equilibrium. That is, aggregate demand is (Y, P) combinations consistent with market clearing in the goods market (IS) and in the money market (LM). The equilibrium equations for this economy are the following: Y = F(K.L) Y = y +a(P - P^e) a> 0 Y =C(Y-T)+I(r) + G M/P = L(r,Y) LRAS: Natural level of output SRAS: Aggregate Supply IS: Goods market clearing LM: Money market clearing Show the short-run effect of and the channel through which an increase in the money supply M uparrow affects the equilibrium output Y, real interest rate r, and price levels P. Show the short-run effect of and the channel through which an increase in government spending G uparrow t affects the equilibrium output Y, real interest rate r, and price levels P.Explanation / Answer
(a) Now with increase in money supply will short term output will also increase as people will be buying more, price levels will also go high with increase in money supply so supply of output will also go up i.e. the new short run equilibrium will be above natural equilibrium. As output has increased so investment will also increase which will happen when interest rates will fall.
b) When government spending increases. It will increase the total output i.e. Y will also increase and this increased spending also puts pressure on interest rates r to increase as IS curve shifts to the right and so the new short-run equilibrium shows higher interest rates. In Keynesian concept, it is assumed that prices are sticky in short-run so here as being a fiscal policy it will not effect price level in short-run.
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