1.

“The Bangladesh Bank has created additional money worth Tk70,794 crore through various
refinance schemes and easing regulatory requirements after the Covid-19 outbreak in March for
stimulating demand to revive the declining economy.” (link:
https://tbsnews.net/economy/banking/bangladesh-bank-creates-money-worth-over-tk70000cr-
revive-economy-76435?
fbclid=IwAR108OXKcbXq6JjZj6v9FbULrDtys_QsZySUTKeAmauoqTjppgnLqU89muw#.Xq5
kdXhgRqq.facebook).  

a) If government increases money supply do you think if will affect product market? How it
will affect i. the price level, value of money, and ii. loanable fund market? Use the
relevant diagrams.

Ans:
Yes, if government increases money supply, it will affect product market.
i. the price level will increase
ii. Demand for loanable fund rises in the loanable fund market.

Explanation with relevant diagram:

If government increases money supply then it will both increase& decrease interest rate and
stimulate the investment in the economy and hence affect the product market. Government uses
the expansionary monetary policy through various tools like open market operation to increase
the money supply in the economy. When money supply increases in the economy the LM curve
shifts to the right as shown in figure below and results in lower rate of interest and the higher
level of income or GDP.
1) Due to increase in money supply in the market, people will have more money to spend, so
their demand rises. As a result of high demand, price level in the market rises and thus the
production will rise.
So, price level in the economy will rise.

2) When interest rate fall, the demand for loanable fund rises and as a result the demand curve
for loanable fund shifts to the right as shown in figure below. Due to shift in demand curve for
loanable fund, the rate of interest rises in the loanable fund market.
The diagram for loanable fund market is following:

b) According to Monetarism, when does an increase in money supply change both Real
GDP and price level? In the short run or in the long run? Explain your answer using a
diagram.

Ans:
According to Monetarism, an increase in money supply change both Real GDP and price level in
the short-run.

Explanation with relevant diagram:

Initially, the economy is in long run equilibrium at point 1 where SRAS1 = AD1 = LRAS. Now,
suppose government increases the money supply and as a result aggregate demand in the
economy rises and AD curve will shift to the right. In the short run there will be an inflationary
gap due to rise in price and demand and results in higher output level. In the long run, due to rise
in wage demand the short run supply curve SRAS1 shifts to left to SRAS2 and this will
continueuntil the new equilibrium (the point 3) is not reached and at that equilibrium output
remains same as full employment level of output and price level will rise to P3.

Thus, in the short run, both the level of GDP and price level are higher. And in long-run only
price level will rise.

c) Do you think creating this additional money will lead to inflation? What type of inflation,
demand-induced or supply-induced? Do you think it will be continued inflation? Why?
Draw a relevant diagram to explain your answer.
Ans:
Yes, I think creating this additional money will lead to demand-induced inflation.
Explanation with relevant diagram:

I think creating this additional money will lead to inflation. This inflation is demand induced
because due to an increase in money supply in the market, people have more money to spend, so
their demand rises. As a result of high demand, the price level in the market raises which results
in an inflationary situation in the economy. Yes, it will be continued inflation without
government intervention because it creates a cycle of demand and supply which keeps changing
according to the fluctuation in the price level. The increase in inflation can be seen through
higher price level and GDP level in the economy as shown in figure below.

2. Suppose recent wave of pessimism engulfs consumers and firms, causing them to reduce their
expenditures. 
a) Demonstrate this event using the model of aggregate demand and aggregate supply and
assuming that the economy was originally in long-run equilibrium. 
Ans:
This event leads to a new equilibrium point 3 where the output level remains same as full
employment level of output and price level will.

Explanation with relevant diagram:

Initially the economy is in long run equilibrium at point 1 where SRAS1 = AD1 = LRAS. Now,
suppose the level of expenditure falls in the market, the aggregate demand in the economy will
fall and as result, in short run the aggregate demand curve shifts to the left. In the long run, due
to fall in price level the wage fall the short run and it reduces the cost of production and as a
result the supply curve SRAS1 shifts to right to SRAS2 and this will continue until the new
equilibrium (the point 3) is not reached and at that equilibrium output remains same as full
employment level of output and price level will fall to P3 as shown in figure below.
b) What is the appropriate activist Fiscal policy response in this regard? In which direction
would the activist policy shift aggregate demand? Use Diagram.
Ans:
Expansionary fiscal policy is the appropriate Fiscal policy response in this regard. The activist
policy shifts aggregate demand to the right.

Explanation with relevant diagram:

In this regard, the appropriate fiscal policy used by policymakers is expansionary fiscal policy
where government can either lower the tax rate or increase the government expenditure.
Suppose, government increases the expenditure, it will directly create the jobs and opportunities
in the market and as a result it will stimulate the consumption and investment level in the
economy. As spending rises, the demand for goods and services rises in the market. This results
in higher aggregate demand. Thus, the aggregate demand shifts to the right as shown in figure.
c) Did the activist fiscal policy destabilize the economy? Explain and Use diagram.
Ans:
Yes, the activist fiscal policy destabilizes the economy in the short-run but in long run economy
will come back to its stable position.

Explanation with relevant diagram:

The activist fiscal policy destabilizes the economy in the short-run but in long-run with
government intervention the economy comes back to stabilize position. In short-run, increase in
spending causes inflationary situation in the economy that will increase the future expectation for
higher wage and ultimately reduces the aggregate supply in the market and results in same full-
employment level of output in the economy.

Point 2 in the graph represents the destabilized situation of the economy where price level is
higher and output level is also higher. But due to shift in supply curve to the left, the economy
comes back to its stable situation (point 3) where output level is equal to the full employment
level of output.