Consider the economy represented by the aggregate demand-aggregate supply (AD/AS
ID: 1198024 • Letter: C
Question
Consider the economy represented by the aggregate demand-aggregate supply (AD/AS) graph below, where output is above full employment output (Y) and unemployment is below the natural rate. If policymakers are concerned about inflation, which countercylical monetary policy would be appropriate to address this concern? decrease taxes just wait until the economy naturally adjusts decrease in interest rates increase in interest rates Adjust the graph to reflect the result of the countercyclical policy action chosen above. Assume the government is aware of the fact that prices are sticky with the downward pressure. The policy should bring the economy back to the full employment level.Explanation / Answer
a)
Increase interest rates
In order to stop inflation from increasing and reduce the price level in the economy, the government should adopt a contractionary monetary policy.
This can be done by decreasing the money supply in the economy, thereby shifting the LM curve to the left and thereby increasing the interest rates.
With decreased money supply, AD will decrease, as people will demand and consume less because of lower money in hand.
This will shift the AD curve to the right, thereby decreasing the price level and thus inflation.
b)
A downward and leftward shift of the AD curve will decrease the price level. The prices will keep on decreasing till the point of intersection of the new AD curve, SRAS and LRAS curve. As a result, prices will decrease and full employment lewvel is achieved.