Consider the AD/AS model built from the IS/LM, with an upward sloping SRAS. The

Question

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.

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?

Explanation / Answer

i. After the leftward shift of the AS curve, the price level will be higher and the output will be below its natural level. If the objective of the government is output stabilization, then the government should increase the aggregate demand so as to shift the AD cuve rightwards (by the way of increasing, say, money supply) and store the output back to its natural level.

ii. After the AS has shifted leftwards, the rise in price level has caused the LM curve to move upwards and therefore before the government takes any step, the interest rate is higher than its natural level. After increase in money supply, the LM curve shifts downward. The government increase the money supply, until the LM curve is back to its original position. Therefore, the interest rate is also back at its original level. The output is also back to the natural level. Since output and interest rate are back to their original levels, the investment is also back to its original level. The consumption which depends on output is also back t its initial level. It is only the price level that has increased.

iii. If the government had not taken any step, then AS would have eventually moved back to its original position. Eventually everything will be the same as in the beginning, even the price level. The only difference is that while the final price level is higher in case government intervenes, the final price level in the case there is no government intervention is the same as its original level.

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