Suppose the economy is initially in long-run equilibrium. The Fed decides to sel

Question

Suppose the economy is initially in long-run equilibrium. The Fed decides to sell bonds. In the short-run, this contractionary monetary policy will cause: A shift from SRAS_1 to SRAS_2 and a movement to point A, with a higher price level and the same output. A shift from AD_2 to AD_1 and a movement to point D, with a lower price level and lower output. A shift from SRAS_2 to SRAS_1 and a movement to point B, with a lower price level and higher output. A shift from AD_1 to AD_2 and a movement to point B. with a higher Click to select your answer.

Explanation / Answer

Initially, the economy is in long-run equilibrium. Now, Fed decides to sell bonds. This means that Fed is undertaking contractionary monetary policy. Such policy results in decrease in money supply and increase in interest rate.

Increase in interest rate raise the cost of borrowing and leads to fall in investment and consumption demand backed by credit which in result leads to decrease in aggregate demand.

So, contractionary monetary policy leads to decrease in aggregate demand or leftward shift in aggregate demand curve.

If we take AD1 as initial aggregate demand curve and it moves to AD2 then this resembles rightward shift of aggregate demand curve which is not possible.

So, AD2 is the initial aggregate demand curve and it has moved leftward to AD1 as a result of contractionary monetary policy.

It has been provided that initially economy is in long-run equilibrium. This means, initially, initial aggregate demand curve, initial short-run aggregate supply curve, and long-run aggregate supply curve are intersecting at one common point.

With AD2 being the initial aggregate demand curve, the common point of intersection can only be point A as only at this point AD2 curve intersect with other two curves (LRAS and SRAS) at one common point (point A).

Thus, initially, economy is at point A with initial aggregate demand curve being AD2, initial short-run aggregate supply curve being SRAS2, and long-run aggregate supply curve being LRAS.

So, with aggregate demand curve shifting leftward from AD2 to AD1, the economy, in short-run, moves to point D. The point of intersection of short-run aggregate supply curve, SRAS2 and new aggregate demand curve, AD1.

This movement of economy will result in lower price level and lower output.

So, in short-run, contractionary monetary policy will cause a shift from AD2 to AD1 and a movement to point D, with lower price level and a lower output.

Hence, the correct answer is option (B).

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