4. The long-run effect of Federal Reserve action (or inaction)in the AD-AS model

Question

4. The long-run effect of Federal Reserve action (or inaction)in the AD-AS model The following graph shows the short-run aggregate supply (SRAS) and aggregate demand (AD) curves for a fictional economy that is producing at point A (grey star symbol), which corresponds to the intersection of the AD and SRAS, curves 100 LRAS 90 No Intervention SRAS 80 SRAS 70 Intervention 0 50 AD 40 AD 2 3 45678 9 QUANTITY OF OUTPUT (Trillions of dollars) 10 According to the graph, potential output of this economy is than actual output, which means that the economy experiences Along SRAS, wages would have been negotiated based on an expected price level of . Since the actual price level at point A is 50, this means that real wages are had been negotiated, which will unemployment If the Fed does not intervene, these labor market conditions would cause nominal wages to , shifting the curve to the . Eventually, the economy would reach a new long-run equilibrium

Explanation / Answer

Potential output is higher than actual output [Since LRAS lies towards right of short run equilibrium GDP], which means economy experiences recession.

At SRAS1, price would be at level of 60 [SRAS1 & LRAS intersection]. Actual price 50, which means real wages are higher, which will increase unemployment.

If Fed doesn't intervene, nominal wages will decrease, shifting SRAS curve to SRAS2.

If Fed intervenes: New equilibrium will be at intersection of LRAS & SRAS1.

Fed will increase money supply which will decrease interest rate, firms get incentive to increase investment, shifting AD1 to AD2.

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