The government decides to use Monetary policy to contract the economy which of t

Question

The government decides to use Monetary policy to contract the economy which of the below would be a concern

A. crowding out B. liquidity trap

C. Inflation

D. stagflation

The theory of sticky wages to explain why the short run aggregate supply curve is upward sloping states that prices are 'sticky'

A. that as government increases spending this will drive up the interest rate which will lead to a decrease in investment

B. temporarily

C. forever and therefore the long run aggregate supply curve should be upward sloping

D. until aggregate demand shifts to the right

Explanation / Answer

Ans a) In order to contract the economy using Monetary policy, the government should ask the central bank to lower its money supply. As Money Supply falls, its immediate impact is a fall in real money supply (LM curve shifts left and up) due to which interest rate rises. This increase in interest rates lowers the investment and hence aggregate demand falls (AD cuve shifts to left and down). Thus, the total output and prices falls. This all happens in the short run. In the medium or long run, the workers start taking into their expectations a fall in prices due to which their real wages start increasing as a result aggregate supply starts increasing (AS shifts to the right and down). This results in increasing Real money supply again and hence, LM curve shifts right and down until it reaches back to its original position. At this point, the original output is restored with original interest rate and lower prices.

Thus the option that is relevant is crowding out (A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.) which will be a concern while using the Monetary policy to contract the economy.

Ans b) The theory of sticky wages to explain why the short run aggregate supply curve is upward sloping states that prices are 'sticky' temporarily as prices can be fixed or remain sticky only in the short run. In the medium run or long run prices are always flexible.

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