Pactice questions for Chapter 5 (Aggregate Demand and Aggregate Supply) 1.Assume oil prices decline. What kind of monetary policy should the Fed undertake if itsgoal is to stabilize the level of output while keeping inflation low? Show with the help ofan AD-AS diagram and briefly explain the adjustment process. Solution:1==>2: As oil prices decline, the cost of production decreases and the upward-sloping AS-curveshifts to the right, causing excess supply of goods. The price level decreases, real moneybalances increase, and the interest rate declines. This will lead to an increase in privatespending and therefore output.2==>3:If the Fed decreases money supply, the interest rate will increase so private spendingwill decrease. Therefore the AD-curve will shift to the left. This means that prices willdecrease even further, but the level of output will now decline. (We assume, for simplicity,that we go back to the full-employment level of output Y*right away, so no further long-runadjustment is needed.) Overall, output will be back at its full-employment level but the pricelevel and the interest rate have decreased. Thus the Fed can successfully lower prices withoutcausing high unemployment.PAD1AS1AD2AS2P11P22P330Y*Y2YThe adjustment process can be described as follows:1==>2: oil prices ↓ ==> cost of production ↓ ==> the AS-curve shifts right== > excess supply ==> P ↓ ==> real ms ↑ ==> i ↓ ==> I ↑ ==> Y ↑Short-run effect: Y ↑ , i ↓,P ↓2==>3: Ms ↓ ==> i ↑ ==> I ↓ ==> Y ↓ ==> the AD-curve shifts left ==> excess supply ==>P ↓ ==> real ms ↑ ==> i ↓ ==> I ↑ ==> Y ↑Short-run effect: Y ↓, i ↑,P ↓Long-run effect: Y back at Y*, i ?, P ↓.
2.Explain the short-run and long-run effects of an increase in government purchases onoutput, unemployment, interest rates, prices, and real money balances.
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