The effect of Federal Reserve action (or inaction) in the AD-AS model The following graph shows an economy that is currently producing at point A (grey star symbol), which corresponds to the intersection of the AD1AD1 and SRAS1SRAS1 curves. According to the graph, the potential output of this economy is $16 trillion $12 trillion $11 trillion $14 trillion $10 trillion . Since real GDP is currently $12 trillion (as shown by point A), this level of potential output means there is currently a recessionary gap an expansionary gap of $3 trillion $4 trillion $1 trillion $5 trillion $2 trillion . Along SRAS1SRAS1, wages would have been negotiated based on an expected price level of 135 140` 145 . Since the actual price level at point A is 140, this means that real wages are lower than the same as higher than had been negotiated, which will decrease increase unemployment. If the Fed does not intervene, these labor market conditions would cause nominal wages to decrease increase , shifting the AD SRAS LRAS curve to the LEFT RIGHT an incentive to investment, shifting the curve to the . On the previous graph, place the black point (plus symbol) at the new long-run equilibrium output and price level if the Fed intervenes in this way and successfully brings the economy back to long-run equilibrium. (Again, assume there are no feedback effects on the curve that does not shift.) Now suppose the Fed chooses to intervene in an effort to move the economy more quickly back to its potential output. To do so, the Fed will increase decrease the money supply, which will increase decrease the interest rate, thereby giving firms an incentive to increase decrease investment, shifting the LRAS AD SRAS curve to the right left . On the previous graph, place the black point (plus symbol) at the new long-run equilibrium output and price level if the Fed intervenes in this way and successfully brings the economy back to long-run equilibrium. (Again, assume there are no feedback effects on the curve that does not shift.) Compare your answers from the previous few questions. If the Fed does not intervene, the economy will likely have relatively high unemployment inflation . On the other hand, if the Fed does intervene, it risks causing relatively high unemployment inflation , if it changes the money supply too much.

The effect of Federal Reserve action (or inaction) in the AD-AS model The following graph shows an economy that is currently producing at point A (grey star symbol), which corresponds to the intersection of the AD1AD1 and SRAS1SRAS1 curves. According to the graph, the potential output of this economy is $16 trillion $12 trillion $11 trillion $14 trillion $10 trillion . Since real GDP is currently $12 trillion (as shown by point A), this level of potential output means there is currently a recessionary gap an expansionary gap of $3 trillion $4 trillion $1 trillion $5 trillion $2 trillion . Along SRAS1SRAS1, wages would have been negotiated based on an expected price level of 135 140` 145 . Since the actual price level at point A is 140, this means that real wages are lower than the same as higher than had been negotiated, which will decrease increase unemployment. If the Fed does not intervene, these labor market conditions would cause nominal wages to decrease increase , shifting the AD SRAS LRAS curve to the LEFT RIGHT an incentive to investment, shifting the curve to the . On the previous graph, place the black point (plus symbol) at the new long-run equilibrium output and price level if the Fed intervenes in this way and successfully brings the economy back to long-run equilibrium. (Again, assume there are no feedback effects on the curve that does not shift.) Now suppose the Fed chooses to intervene in an effort to move the economy more quickly back to its potential output. To do so, the Fed will increase decrease the money supply, which will increase decrease the interest rate, thereby giving firms an incentive to increase decrease investment, shifting the LRAS AD SRAS curve to the right left . On the previous graph, place the black point (plus symbol) at the new long-run equilibrium output and price level if the Fed intervenes in this way and successfully brings the economy back to long-run equilibrium. (Again, assume there are no feedback effects on the curve that does not shift.) Compare your answers from the previous few questions. If the Fed does not intervene, the economy will likely have relatively high unemployment inflation . On the other hand, if the Fed does intervene, it risks causing relatively high unemployment inflation , if it changes the money supply too much.

Principles of Economics 2e

2nd Edition

ISBN:9781947172364

Author:Steven A. Greenlaw; David Shapiro

Publisher:Steven A. Greenlaw; David Shapiro

Chapter32: Macroeconomic Policy Around The World

Section: Chapter Questions

Problem 9SCQ: Show, using the AD/AS model, how governments can use monetary policy to decrease the price level.

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The effect of Federal Reserve action (or inaction) in the AD-AS model

The following graph shows an economy that is currently producing at point A (grey star symbol), which corresponds to the intersection of the AD1AD1 and SRAS1SRAS1 curves.

According to the graph, the potential output of this economy is

$16 trillion

$12 trillion

$11 trillion

$14 trillion

$10 trillion

Since real GDP is currently $12 trillion (as shown by point A), this level of potential output means there is currently

a recessionary gap

an expansionary gap

$3 trillion

$4 trillion

$1 trillion

$5 trillion

$2 trillion

Along SRAS1SRAS1, wages would have been negotiated based on an expected price level of

135

140`

145

. Since the actual price level at point A is 140, this means that real wages are

lower than

the same as

higher than

had been negotiated, which will

decrease

increase

unemployment. If the Fed does not intervene, these labor market conditions would cause nominal wages to

decrease

increase

, shifting the

SRAS

LRAS

curve to the

LEFT

RIGHT

an incentive to investment, shifting the curve to the .

On the previous graph, place the black point (plus symbol) at the new long-run equilibrium output and price level if the Fed intervenes in this way and successfully brings the economy back to long-run equilibrium. (Again, assume there are no feedback effects on the curve that does not shift.)

Now suppose the Fed chooses to intervene in an effort to move the economy more quickly back to its potential output. To do so, the Fed will

increase

decrease

the money supply, which will

increase

decrease

the interest rate, thereby giving firms an incentive to

increase

decrease

investment, shifting the

LRAS

SRAS

curve to the

right

left

Compare your answers from the previous few questions. If the Fed does not intervene, the economy will likely have relatively high

unemployment

inflation

. On the other hand, if the Fed does intervene, it risks causing relatively high

unemployment

inflation

, if it changes the money supply too much.

LRAS
SRAS,
165
160
No Intervention
SRAS,
155
150
If Fed Intervenes
145
140
AD2
135
AD,
130
125
10
11
12
13
14
15
16
17
18
REAL GDP (Trillions of dollars)
PRICE LEVEL

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