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 (it’s 110 instead of 105). 2. the price level is higher than in the (previous) long run equilibrium

since resource costs will not keep up with the higher price level for products (see below) 4. Real wages and resource price will be bid up. Therefore. as a result of the higher price level. the self-correcting mechanism or also known as the invisible hand.Exhibit 1. producers will produce more output in the short run than in the previous long run equilibrium. output (real GDP) will be higher than in long run equilibrium (and higher than the potential.2 3. producers expand their production in response. sustainable. decreasing short run aggregate . 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. employment is greater than full employment 6. a metaphor commonly known to economist conceived by Adam Smith describing the self-regulating behaviour of the market place. real interest rates will be lower than long run equilibrium values . and thus increase demand for resources. cyclical unemployment is negative (which can happen temporarily) 8. full employment level). In the event that the short-run equilibrium exists the resource market is highly affected. As the aggregate demand start to move rightward. the non-activist approach will be used. unemployment is lower than the natural rate (this can occur temporarily) 7. 5.

the price level is higher than in the (previous) long run equilibrium 3. and that’s consistent with expectations) 2. raising the real interest rate. setting a new equilibrium in a long run level. the price level is as expected (it’s 117 now. 1. Therefore this newly established equilibrium in a long run reflect the restored real wages and resource prices (Exhibit 1. even though the price level is higher than the previous equilibrium.3) Exhibit 1. As this occurs. since resource prices have caught up with product prices. .supply.3 At the final long run equilibrium (3). the price level will rise. producers do not want to produce more than the long run potential GDP.

4. as the economy slides up the aggregate demand curve to the new long run equilibrium. So 1 the new short run-equilibrium is at E with an increase in both output and the price level. the rate of output exceeds the potential output of the economy. where in point E is the original point of Equilibrium. output (real GDP) will be the potential. real wages return to their original level. we can see the effects by referring on exhibit 1. full employment level. However. 9.4 To make the discussion short. 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. One the general public learned the activity or the situation of the economy. 6. 7. 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. Exhibit 1. sustainable. real interest rates will rise back to their original level. employment unemployment cyclical is is equal at unemployment to the full employment natural is rate zero 8. .4. 5. even though nominal wages are higher than before.

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

leads to lower planned investment. the increase in interest rates causes consumption and investment spending to fall and so aggregate demand falls 3. The effects of contractionary monetary policy are summarized Let us look at this graphically: AS – AD market. . the decrease in aggregate demand causes real GDP to fall Contractionary monetary policy consists of reductions in the money supply. a decrease in the money supply causes interest rates to rise 2. as with contractionary fiscal policy. However. This will lead to a reduction in aggregate output.1. which has the effect of offsetting the increase in interest rates to some degree. as a result. the reduction in aggregate output will reduce the demand for money. This increases interest rates and.

Lower r will cause firms to undertake new investment (I).The economy is initially in equilibrium at point (a). 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. prices were fixed in the economy and we had a horizontal SRAS curve (i. prices did not change in the short run). This will cause real interest rates (r) to fall. recessions will be more severe (larger decreases in Y). even if prices are fixed. interest rates will fall!). Please be noted that P0 is the initial price level in the economy. 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 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. 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). if prices were fixed at P0. <<Regardless of whether prices are fixed in the short run. 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. shifting out the LM curve. An increase in M/P increases the real supply of money. In this case. The new short run equilibrium is at (b). Let’s look at the IS-LM market to see the effects on interest rates and investment! .. So. Why is that? If firms lower prices with a negative demand then the lower prices will increase real money balances . we assume nominal wages are always fixed in the short run. As the AD curve shifts in (due to lower government spending).e. Suppose.

Like in the AS-AD market. The lower prices due to lower demand for goods will increase real money balances and shift out the LM curve slightly. interest rates will fall (and investment will rise) for two reasons: 1. If interest rates did not fall because of the fall in the demand for money. Remember. We know from the AS-AD graph that output will definitely fall. 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). M/P rises. output only falls from (a) to (b).As P falls. Real money increases. This. This causes us to move to point (c). If prices were fixed. 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 . The lower interest rates will spur on investment. the fall in GDP would be a lot more severe (we would move to point (d) . Remember. rates. will not shift any of the curves. investment will increase. the economy would move from (a) to (c). you get an extra kick to investment. With prices allowed to adjust. As G. just not as much because prices increase real money supply.the point where interest rates are fixed!). the economy would move from (a) to (d). This causes interest rates to fall (as does output). which further reduces interest Both of these cause I to increase. however. If prices were fixed (no effect on real money supply). the IS curve represents the goods side of the market Y = C + I + G + NX just like the aggregate demand (AD) curve. If I did not respond. decreases the IS curve (and the AD curve – they are both the same – just drawn in different spaces) will fall. In our model. we are allowing firms to adjust prices. that would be the end of the story in the short run. This is . We would end up at point (c) in the economy (same point (c) from AD-AS graph). As G falls. In this case. 2. 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. But. as interest rates fall as output falls (due to lower money demand). The change in investment as interest rates change is represented by the slope of the curves! So. The lower money demand will drive down interest rates (this is represented as point (c) on the above graph).lowering the price of savings .this is the IS-LM analysis). investment will pick up and offset some of the fall in output. a fall in G will shift in the goods demand curve. 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. there are no new shifts! As interest rates fall.

As a rule (see the notes from Thursday). G falls. N will be less than N*. national savings increases (I increases and NX stays the same). How do we get back to N* (and Y*)? Here is where some fun begins. So. N < N*. Y falls. I increases (but by a smaller amount then G falls – we know in the end that output falls). Cyclical unemployment rises. r falls. population or the value of leisure do not change so labor supply (NS) does not change. taxes. Summarizing the Short Run Effects of a fall in government spending if we well discuss the matter in te short run equilibrium. N*0 = N*1. Remember we are not in equilibrium (we may not be on either the labor supply or the labor demand curves). all we know about N in the short run is that if Y < Y*. P falls. We stated in class (and above) when N > N*. workers will put . PVLR. we are in a recession! What happens in the long run? Which is the matter of the question that need to be answer. real wages rise in the short term (nominal wages are fixed and prices fall). NX and C stay the same.which was the old equilibrium. In the short run.subtle!!!! Try hard to understand what role changing prices and changing output has on investment. 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. There will be no shifts in the labor supply or labor demand curves. The new equilibrium in the economy is (z) which is the same as (a) .

In this case. There is unemployment and output falls below the economy’s potential output. From the point E2 . it will eventually correct itself causing nominal wages to rise or fall. The self-correcting mechanism refers to the fact that when the labor market is in disequilibrium. . workers will generally respond quickly.). Once the people learned about the current market situation and realize the effect. firms will want to CUT nominal wages. The reduction in government spending shifts the aggregate demand curve from AD1 to AD. I will define a recession as being when Y is below Y* . and the new short-run equilibrium is at E3 .pressure on firms to increase wages. the short –run aggregate supply curve shift to AS1 and E is the new longrun equilibrium of the given market.correcting mechanism. Here we have N < N*.Firms will be hesitant to cut nominal wages (money illusion). firms may not like to cut nominal wages. The reverse is not true-. As a result. When N > N*. we may tend to stay in recessions longer than we would stay above Y* (From now on. we tend to believe that the economy will correct itself quickly. Therefore to make the topic short. This is an important concept for you to understand for our next quizzes and the final exam. The process of wages adjusting to restore the economy to its long run level is often called the self. please refer to the graph on the left. Nominal wages will increase. As we talked about early in the class.this is slightly different than the technical definition. If you ask workers to work harder than their wage says they should.

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