Use the following information for the next 4 questions. You should draw a graph

Question

Use the following information for the next 4 questions. You should draw a graph that depicts the situation below and use your picture to answer the questions.

Assume that wages and prices are sticky and that we start at a long-run equilibrium. Assume that at this initial point, the growth rate of the money supply is 2%, the growth rate of the velocity of money is 6% and inflation is 5%.

Now assume that people begin to fear losing their jobs and businesses begin to worry about future demand for their goods and services. This causes the growth rate of consumption and the growth rate of investment to fall. After the fall in the growth rates of consumption and investment, the total spending growth for the AD curve is 4%.

Now assume that the Federal Reserve decides to increase the growth rate of the money supply in order to combat the drop in Consumption and Investment. When the Federal Reserve increases the growth rate of the money supply, the Federal Reserve gets its monetary policy just right and gets the economy back to where it started in terms of inflation and real economic growth.

1 When consumption and investment fall, the _____ curve shifts _____.

2 After consumption and investment fall and before Federal Reserve action (Point 2), what is the real economic growth rate in your graph?

3 After the Federal Reserve increases the growth rate of the money supply (Point 3), what is the growth rate of the money supply?

4 After the Federal Reserve increases the growth rate of the money supply (Point 3), what is the growth rate of the velocity of money?

Explanation / Answer

1. When consumption and investment fall, aggregate demand will reduce. Thus IS curve will shift left.

2. growth in money supply + growth in velocity = inflation + growth in output

growth in output = 3%

3. Fed increases the money supply by 1% to increase AD growth to 4%.

4. Growth rate of velocity = 6%

velocity will remain same.

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