Question

Suppose the economy is in long-run equilibrium, with real GDP at $19 trillion and the unemployment rate at 5%. Now assume that the central bank unexpectedly decreases the money supply by 6%. 1. Illustrate the short-run effects on the macroeconomy by using the AD/AS model. a. In which direction will GDP change? b. In which direction will the price level move? c. In which direction will unemployment move? 2. Illustrate the long-run effects on the macroeconomy by using the AD/AS model. a. In which direction will GDP change? b. In which direction will the price level move? c. In which direction will unemployment move? 3. Now assume this monetary contraction was completely expected. Illustrate both short-run and long-run effects on the macroeconomy by using the AD/AS model. a. In which direction will GDP change? b. In which direction will the price level move? c. In which direction will unemployment move?

Answer 1

In the short run, an unexpected monetary contraction decreases GDP, lowers the price level, and may increase unemployment. In the long run, the economy tends to return to its initial equilibrium. If expected, short-run effects persist briefly.

1. Short-Run Effects (Unexpected Monetary Contraction):

a. GDP: GDP will likely decrease.

b. Price Level: The price level will likely decrease due to reduced demand.

c. Unemployment: Unemployment may increase as economic activity contracts.

2. Long-Run Effects (Unexpected Monetary Contraction):

a. GDP: In the long run, GDP will tend to return to the initial level.

b. Price Level: The price level will stabilize or experience a smaller decline.

c. Unemployment: Unemployment may return to the initial level in the long run.

3. Combined Short-Run and Long-Run Effects (Expected Monetary Contraction):

a. GDP: GDP may still decrease in the short run but should return to the initial level in the long run.

b. Price Level: The price level may initially decrease but stabilize or experience a smaller decline in the long run.

c. Unemployment: Unemployment may temporarily increase in the short run but return to the initial level in the long run.

In all scenarios, the long-run effects emphasize that the economy tends to return to its initial equilibrium level over time, with adjustments in price levels and unemployment.