The following graph shows an economy that is currently producing at point A (grey star symbol), which corresponds to the intersection of the AD1
and SRAS1
curves.
No Intervention
If Fed Intervenes
10
11
12
13
14
15
16
17
18
165
160
155
150
145
140
135
130
125
PRICE LEVEL
REAL GDP (Trillions of dollars)
AD
1
AD
2
SRAS
1
SRAS
2
LRAS
A
According to the graph, the potential output of this economy is .
Since real GDP is currently $12 trillion (as shown by point A), this level of potential output means there is currently of .
Along SRAS1
, wages would have been negotiated based on an expected price level of . Since the actual price level at point A is 140, this means that real wages are had been negotiated, which will unemployment. If the Fed does not intervene, these labor market conditions would cause nominal wages to , shifting the curve to the . Eventually, the economy would reach a new long-run equilibrium.
On the previous graph, use the tan point (dash symbol) to indicate the long-run equilibrium output and price level if the Fed does not intervene. (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 the money supply, which will the interest rate, thereby giving firms 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.)
Compare your answers from the previous few questions. If the Fed does not intervene, the economy will likely have relatively high . On the other hand, if the Fed does intervene, it risks causing relatively high , if it changes the money supply too much.
According to the graph, the potential output of this economy is located at point LRAS, where the LRAS curve intersects with AD1.
Since real GDP is currently $12 trillion (as shown by point A), this level of potential output means there is currently an output gap of $2 trillion (potential output - actual output = $14 trillion - $12 trillion = $2 trillion).
Along SRAS1, wages would have been negotiated based on an expected price level of 155. Since the actual price level at point A is 140, this means that real wages are higher than what had been negotiated, which will lead to higher unemployment. If the Fed does not intervene, these labor market conditions would cause nominal wages to decrease, shifting the SRAS1 curve to the left. Eventually, the economy would reach a new long-run equilibrium.
On the previous graph, use the tan point (dash symbol) to indicate the long-run equilibrium output and price level if the Fed does not intervene. (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 the money supply, which will decrease the interest rate, thereby giving firms an incentive to increase investment, shifting the AD curve to the right.
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. On the other hand, if the Fed does intervene, it risks causing relatively high inflation, if it changes the money supply too much.