Modern Macroeconomics and Monetary Policy: Aplia Homework The following graph sh

Question

Modern Macroeconomics and Monetary Policy: Aplia Homework 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 80 T LRAS 70 t No Intervention SRAS1 60 SRAS2 50 + 30 AD 20 AD 10 t QUANTITY OF OUTPUT (Trillions of dollars) V than actual output, which means that the economy experiences According to the graph, potential output of this economy is

Explanation / Answer

Since equilibrium occurs well before the LRAS, potential output is greater than actual output and hence, the economy experiences a recession or deflationary gap.

Wages must have been negotiated at their expected long-run price level of 40, now when the price level is actually 30, real wages are more than what they had been negotiated. So this will increase the supply of labor and cause more unemployment.

Without intervention, nominal wages would fall shifting the SRAS1 to the right to SRAS2.

When the Fed intervenes, it stimulates the AD since actual GDP falls short of its potential level and it does so by increasing money supply, which reduces interest rate, giving incentive to firms to increase investment shifting the AD curve to the right.

Compare: when the Fed does not intervene, it causes the economy a lower price level and when it intervenes, the prices are higher.

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