Suppose the economy is in a long-run equilibrium. a.

What would be the short-run and the long-run effects of an increase in the money supply? b. What would be the short-run and long-run effects of a decrease in government spending? A. Expansionary Monetary Policy Thusfar in our initial policy discussion of the monetary policies, the designed of the shift of the demand curve will help for better understanding of the factors affecting the implementation of expansionary monetary policy. The effect of an increase in the money supply in a long run eqilibrium, with the price level equal to that anticipated by the policy makers. On the grahical presentation ( Exhibit 1.1 ) it represent the intersection of the 105 price lvel against the line of LRAS ( Long Run Aggregate Supply) which is fixed ant time given.

Exhibit 1.1
From the given starting point on the given situation presented, the BSP (Philippine Setting) increases the money supply, therefore the bank will increase their lending activity to their consumers, prospective investors and in the rest of the business community. When the suply of loans goes up, the real interest rate will fall. And as rthe interest rates fall, aggregate demand will increase, there is a shift of the demand curve to the right, will result in the short-run equilibrium. In the short-run equilibrium represent on the right side, which point 2 (Exhibit 1.2 ): 1. the price level is higher than what was expected (its 110 instead of 105). 2. the price level is higher than in the (previous) long run equilibrium

Exhibit 1.2
3. as a result of the higher price level, producers will produce more output in the short run than in the previous long run equilibrium, since resource costs will not keep up with the higher price level for products (see below) 4. output (real GDP) will be higher than in long run equilibrium (and higher than the potential, sustainable, full employment level). 5. employment is greater than full employment 6. unemployment is lower than the natural rate (this can occur temporarily) 7. cyclical unemployment is negative (which can happen temporarily)

8. the real values of wages and resource prices will be lower than their lower than their long run equilibrium levels (due to the higher than expected price level) 9. real interest rates will be lower than long run equilibrium values . In the event that the short-run equilibrium exists the resource market is highly affected. Therefore, the non-activist approach will be used, the self-correcting mechanism or also known as the invisible hand, a metaphor commonly known to economist conceived by Adam Smith describing the self-regulating behaviour of the market place. As the aggregate demand start to move rightward, producers expand their production in response, and thus increase demand for resources. Real wages and resource price will be bid up, decreasing short run aggregate

supply. As this occurs, the price level will rise, raising the real interest rate, setting a new equilibrium in a long run level. Therefore this newly established equilibrium in a long run reflect the restored real wages and resource prices (Exhibit 1.3)

Exhibit 1.3

At

the

final

long

run

equilibrium

(3),

1. the price level is as expected (its 117 now, and thats consistent with expectations) 2. the price level is higher than in the (previous) long run equilibrium 3. even though the price level is higher than the previous equilibrium, producers do not want to produce more than the long run potential GDP, since resource prices have caught up with product prices.

4. output (real GDP) will be the potential, sustainable, full employment level. 5. 6. 7. employment unemployment cyclical is is equal at unemployment to the full employment natural is rate zero

8. real wages return to their original level, even though nominal wages are higher than before. 9. real interest rates will rise back to their original level, as the economy slides up the aggregate demand curve to the new long run equilibrium.

Exhibit 1.4

To make the discussion short, we can see the effects by referring on exhibit 1.4; where in point E is the original point of Equilibrium. The increase in the money supply causes the aggregate demand curve to shift to the right as falling interest rates stimulate investment spending in the market. So 1 the new short run-equilibrium is at E with an increase in both output and the price level. However, the rate of output exceeds the potential output of the economy. One the general public learned the activity or the situation of the economy, the short run aggregate supply (AS) curve will shift to the left AS2 and the new long run equilibrium will be set on the new point at E2.

B. The Impact of Government spending on Growth in the Short and Long run ( Contractionary Monetary Policy) Managing the economy through expansionary and contractionary monetary policy has been a standard practice in any country when the concept was first introduced by economist John Maynard Keynes. Monetary expansion increases the amount of money circulated in the economy. Monetary contraction pulls money out of the economy and is most often used to cool off a hot economy to prevent inflation. The main purpose of a contractionary monetary policy is to slow down the rampant inflation that accompanies a booming economy. The government uses several methods to do this, including slowing its own spending. The Fed can raise interest rates, making money more expensive to borrow. Slowing inflation by reining in economic growth cools off the markets and brings down overall demand--and prices go down with demand. Production is reduced in the economy as a by-product of slowing the economic engine. More expensive investment capital and a reduced demand for products and services are the culprits. Once companies gear down production, it can take years to ramp it up again. If the contractionary monetary policy overshoots the mark and tightens the economy more severely than intended, companies can button down production and shutter planned expansions. This can throw the economy into a recessionary loop Inflation causes ever-increasing prices, which can negatively impact consumer spending power. This price fluctuation can make consumers nervous and erratic in their spending patterns. A monetary contraction stabilizes prices in the market as the inflation slows. This increase in consumer confidence keeps the economy on an even keel and encourages stable spending patterns. Increased unemployment results from the slowing production and increasing interest rates. As companies slow their growth rates, they hire fewer employees. Increases in unemployment cost the government in increased unemployment insurance administration costs and social services expenses. Governments must carefully weigh this cost against the economic benefits of reducing inflation. Higher unemployment rates can also shake consumer confidence if the spike happens rapidly. Increases in unemployment reduces the demand for many products and services, making the economic contraction more severe.

To decrease the money supply, the Federal Reserve can sell government bonds (an open market sale) raise the discount rate raise the reserve ratio Contractionary monetary policy is appropriate when inflation is a problem.

1. a decrease in the money supply causes interest rates to rise 2. the increase in interest rates causes consumption and investment spending to fall and so aggregate demand falls 3. the decrease in aggregate demand causes real GDP to fall

Contractionary monetary policy consists of reductions in the money supply. This increases interest rates and, as a result, leads to lower planned investment. This will lead to a reduction in aggregate output. However, as with contractionary fiscal policy, the reduction in aggregate output will reduce the demand for money, which has the effect of offsetting the increase in interest rates to some degree. The effects of contractionary monetary policy are summarized

Let us look at this graphically: AS AD market.

The economy is initially in equilibrium at point (a). As the AD curve shifts in (due to lower government spending), prices should fall (from P0 to P1) AND equilibrium level of output should fall to Y1 which I refer to as the equilibrium GDP in the short run. The new short run equilibrium is at (b). Please be noted that P0 is the initial price level in the economy. Suppose, prices were fixed in the economy and we had a horizontal SRAS curve (i.e., prices did not change in the short run). In this case, if prices were fixed at P0, the leftward shift of the AD curve would result in the economy ending up at point (c) (where output is equal to Yp (the output level which would have occurred if prices where fixed)). The fall in GDP would be bigger (from a given change in AD) if prices were fixed than if firms were allowed to adjust prices (point b versus c). Why is that? If firms lower prices with a negative demand then the lower prices will increase real money balances . An increase in M/P increases the real supply of money, shifting out the LM curve. This will cause real interest rates (r) to fall. Lower r will cause firms to undertake new investment (I). GDP does not fall as much when prices are allowed to adjust because the change in prices will cause interest rates to fall further and spur on some new additional investment (as we will see in a second, even if prices are fixed, interest rates will fall!). So, the fall in G is offset by an additional increase in I when prices adjust! Firms adjusting their prices will dampen the effect of recessions! If prices are sticky in the economy, recessions will be more severe (larger decreases in Y). <<Regardless of whether prices are fixed in the short run, we assume nominal wages are always fixed in the short run. Lets look at the IS-LM market to see the effects on interest rates and investment!

Like in the AS-AD market, a fall in G will shift in the goods demand curve. Remember, the IS curve represents the goods side of the market Y = C + I + G + NX just like the aggregate demand (AD) curve. As G, decreases the IS curve (and the AD curve they are both the same just drawn in different spaces) will fall. This causes interest rates to fall (as does output). A lower level of output will decrease the demand for money (we need less money in the economy because there is less stuff to buy). The lower money demand will drive down interest rates (this is represented as point (c) on the above graph). The lower interest rates will spur on investment. If interest rates did not fall because of the fall in the demand for money, the fall in GDP would be a lot more severe (we would move to point (d) - the point where interest rates are fixed!). But, as interest rates fall as output falls (due to lower money demand), investment will pick up and offset some of the fall in output. This causes us to move to point (c). If prices were fixed, that would be the end of the story in the short run. We would end up at point (c) in the economy (same point (c) from AD-AS graph). In our model, we are allowing firms to adjust prices. The lower prices due to lower demand for goods will increase real money balances and shift out the LM curve slightly. This will lower interest rates a little bit further and spur on some ADDITIONAL investment so output will not fall quite as far as it would if prices were fixed. We know from the AS-AD graph that output will definitely fall, just not as much because prices increase real money supply. The two shifts together the fall in the IS and the increase in the LM will create a new equilibrium at point (b) with output equal to Y1. Remember, there are no new shifts! As interest rates fall, investment will increase. This, however, will not shift any of the curves. The change in investment as interest rates change is represented by the slope of the curves!

So, interest rates will fall (and investment will rise) for two reasons: 1. As G falls, Y will fall and the demand for money will fall (this is balanced with the fact that lower G implies less government borrowing and/or more government savings - lowering the price of savings - this is the IS-LM analysis). 2.As P falls, M/P rises. rates. Real money increases, which further reduces interest

Both of these cause I to increase. If I did not respond, the economy would move from (a) to (d). If prices were fixed (no effect on real money supply), the economy would move from (a) to (c). With prices allowed to adjust, you get an extra kick to investment. In this case, output only falls from (a) to (b). This is

subtle!!!! Try hard to understand what role changing prices and changing output has on investment. There will be no shifts in the labor supply or labor demand curves. Remember we are not in equilibrium (we may not be on either the labor supply or the labor demand curves). As a rule (see the notes from Thursday), all we know about N in the short run is that if Y < Y*, N will be less than N*. Summarizing the Short Run Effects of a fall in government spending if we well discuss the matter in te short run equilibrium. Y falls, P falls, r falls, G falls, I increases (but by a smaller amount then G falls we know in the end that output falls), NX and C stay the same, real wages rise in the short term (nominal wages are fixed and prices fall), national savings increases (I increases and NX stays the same). Cyclical unemployment rises; we are in a recession! What happens in the long run? Which is the matter of the question that need to be answer.

There is no effect of changing G on labor supply or labor demand! A and K do not change so labor demand (Nd) does not change. PVLR, taxes, population or the value of leisure do not change so labor supply (NS) does not change. So, N*0 = N*1. The new equilibrium in the economy is (z) which is the same as (a) - which was the old equilibrium.

In the short run, N < N*. How do we get back to N* (and Y*)? Here is where some fun begins. We stated in class (and above) when N > N*, workers will put

pressure on firms to increase wages. Nominal wages will increase. Here we have N < N*. In this case, firms will want to CUT nominal wages. As we talked about early in the class, firms may not like to cut nominal wages.

The process of wages adjusting to restore the economy to its long run level is often called the self- correcting mechanism. This is an important concept for you to understand for our next quizzes and the final exam. The self-correcting mechanism refers to the fact that when the labor market is in disequilibrium, it will eventually correct itself causing nominal wages to rise or fall. When N > N*, we tend to believe that the economy will correct itself quickly. If you ask workers to work harder than their wage says they should, workers will generally respond quickly. The reverse is not true-- Firms will be hesitant to cut nominal wages (money illusion). As a result, we may tend to stay in recessions longer than we would stay above Y* (From now on, I will define a recession as being when Y is below Y* - this is slightly different than the technical definition.).

Therefore to make the topic short, please refer to the graph on the left. From the point E2 . The reduction in government spending shifts the aggregate demand curve from AD1 to AD, and the new short-run equilibrium is at E3 , There is unemployment and output falls below the economys potential output. Once the people learned about the current market situation and realize the effect, the short run aggregate supply curve shift to AS1 and E is the new longrun equilibrium of the given market.