2 Suppose the Fed reduces the money supply by 5 percent Assu

2. Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. a. What happens to the aggregate demand curve? b. What happens to the level of output and the price level in the short run and in the long run?

Solution

2. a. If the Fed reduces the money supply, given the velocity is constant. then the aggregate demand curve shifts down. The result is based on the quantity equation MV = PY which means a decrease in money supply leads to a proportionate decrease in nominal output PY.

2. b. In the short-run, we assume that price level is fixed and that the aggregate supply curve is flat. In the short-run, the leftward shift in the aggregate demand curve leads to a movement such that output falls but the price level doesn’t change. In the long-run, prices are flexible, as prices fall, the economy returns to full employment.

2. c. Okun’s law refers to the negative relationship that exists between unemployment and real GDP. Which means, output moves in the opposite direction from unemployment with a ratio of 2 to 1. In the short-run, when output falls, unemployment rises. Okun’s law states that output growth equals the full employment growth rate of 3 percent minus two times the change in the unemployment rate. In the long-run, both unemployment and output return to their natural rate levels. Hence, there is no long-run change in unemployment.

2. d. If output falls, it causes the real interest to rise in the short-run. In the long-run, when Y returns to its origianl position so does the real interest rate.

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