HW5_sol - Chapter 9 d. Introduction to Economic...

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d. The decrease in velocity causes the aggregate demand curve to shift downward. The Fed could increase the money supply to offset this decrease and thereby return the economy to its original equilibrium at point A, as in Figure 9–7. To the extent that the Fed can accurately measure changes in velocity, it has the ability to reduce or even eliminate the impact of such a demand shock on output. In particular, when a regulatory change causes money demand to change in a pre- dictable way, the Fed should make the money supply respond to that change in order to prevent it from disrupting the economy. e. The decrease in velocity shifts the aggregate demand curve down and to the left. In the short run, the price level remains the same and the level of output falls below the natural rate. If the Fed wants to stabilize output and return it to the natural rate, they should increase the money supply. Note that increasing the money supply in this case will stabilize both output and the price level so that the answer here is the same as in part d. 2. a. If the Fed reduces the money supply, then the aggregate demand curve shifts down, as in Figure 9–8. This result is based on the quantity equation MV = PY , which tells us that a decrease in money M leads to a proportionate decrease in nominal output PY (assuming that velocity V is fixed). For any given price level P , the level of output Y is lower, and for any given Y , P is lower. Chapter 9 Introduction to Economic Fluctuations 81 SRAS Y Y Income, output A LRAS P Price level AD 2 AD 1 Figure 9–7 LRAS SRAS Y Income, output P P Y AD 2 AD 1 Figure 9–8
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b. In the short run, we assume that the price level is fixed and that the aggregate supply curve is flat. As Figure 9–9 shows, in the short run, the leftward shift in the aggregate demand curve leads to a movement from point A to point B—output falls but the price level doesn’t change. In the long run, prices are flexible. As prices fall, the economy returns to full employment at point C. If we assume that velocity is constant, we can quantify the effect of the 5-per- cent reduction in the money supply. Recall from Chapter 4 that we can express the quantity equation in terms of percentage changes: % Δ in M + % Δ in V = % Δ in P + % Δ in Y . If we assume that velocity is constant, then the % Δ in V = 0. Therefore, % Δ in M = % Δ in P + % Δ in Y . We know that in the short run, the price level is fixed. This implies that the % Δ in P = 0. Therefore, % Δ in M = % Δ in Y . Based on this equation, we conclude that in the short run a 5-percent reduction in the money supply leads to a 5-percent reduction in output. This is shown in Figure 9–9. In the long run we know that prices are flexible and the economy returns to its natural rate of output. This implies that in the long run, the % Δ in Y = 0.
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This note was uploaded on 10/04/2011 for the course ECON 101b taught by Professor Staff during the Spring '08 term at University of California, Berkeley.

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HW5_sol - Chapter 9 d. Introduction to Economic...

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