1. Consider the AD/AS model built from the IS/LM, with an upward sloping SRAS. T
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Question
1. Consider the AD/AS model built from the IS/LM, with an upward sloping SRAS. The economy was operating at full employment, but it is suddenly hit by unfavorable weather conditions, which increases the expected price level and shifts the SRAS to the left.
a. Assume that the government decides to keep its policy unchanged.
i. What should the central bank of this country do if its main objective is output stabilization in the short run?
ii. What are the effects of this policy on the price level, output, the real interest rate, consumption and investment? iii. Compare the long-run equilibrium after this policy is implemented with the long-run equilibrium that this country would have reached without policy intervention. Are the price level, output, real interest rate, consumption and investment different?
b. Assume that the government decides to keep its policy unchanged.
i. What should the central bank of this country do if its main objective is to avoid price increases in the short and long run?
ii. What are the effects of this policy on the price level, output, the real interest rate, consumption and investment? iii. Compare the long-run equilibrium after this policy is implemented with the long-run equilibrium that this country would have reached without policy intervention. Are the price level, output, real interest rate, consumption and investment different?
2. Consider the AD/AS model built from the IS/LM. The economy was operating at full employment, but it is suddenly hit by a negative demand shock in the form of a decrease in planned investment at each level of the real interest rate.
a. Show the impact of the negative demand shock in the Keynesian cross diagram and in the IS/LM graph.
b. Show what will happen in the Keynesian cross diagram and in the IS/LM graph if the government decides to increase spending in order to contrast the negative demand shock. Assume that the increase in government spending successfully bring output back to the full employment level.
c. Compare the initial full employment equilibrium (before the negative demand shock) with the new long run equilibrium after the government policy intervention. Is the level of investment different? Is the level of consumption different? Explain your answer.
Explanation / Answer
(1)
(a)
(i) Since government wants its policy to remain unchanged, no fiscal policy changes take effect. Output has to be stabilized using monetary policy.
Higher price level increases inflation, so to tame inflation, contractionary monetary policy should be adopted. So, Central bank can sell government securities in an open market operation, to mop up excess money supply in the economy.
It can also be done using higher bank rate or higher reserves requirements.
(ii) This policy will lower price level, which will increase demand & output. Consumption will rise due to lower inflation. Interest rates will fall, causing investment demand to rise.
(iii) In the long run, such policy will lower output because producers will reduce output due to low prices. Long run effect of this will eventually raise prices again. So, long run output will be lower, price level will be higher and consumption will fall. Interest rate will rise & investment demand will fall.
(b)
(i) To avoid price increase, money supply must be controlled. The analysis is exactly like in part (a).
Higher price level increases inflation, so to tame inflation, contractionary monetary policy should be adopted. So, Central bank can sell government securities in an open market operation, to mop up excess money supply in the economy.
It can also be done using higher bank rate or higher reserves requirements.
(ii) This policy will lower price level, which will increase demand & output. Consumption will rise due to lower inflation. Interest rates will fall, causing investment demand to rise.
(iii) In the long run, such policy will lower output because producers will reduce output due to low prices. Long run effect of this will eventually raise prices again. So, long run output will be lower, price level will be higher and consumption will fall. Interest rate will rise & investment demand will fall.
Note: Out of 2 questions, the first one is answered in full.
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