# 6. Monetary Policy in the Long RunConsider a hypothetical economy that produces at its long-run macroeconomic equilibrium at a price level of 100.Suppose that the central bank in this economy is expanding the money supply by 4% each year. In order for the price level to be maintained at 100, real GDP must grow at an annual rate of ___% if the velocity of money remains constant.Suppose the central bank enacts an unanticipated expansionary monetary policy. As a result, the supply of loanable funds ________, leading to a ___ in short-term interest rates.The following graph shows the goods and services market of this economy at full employment. Assume that potential output remains constant.## Graph Explanation**Graph Title:** The Market for Goods and Services- **Axes:** - **Vertical Axis (Y-axis):** Price Level - **Horizontal Axis (X-axis):** Real GDP- **Lines:** - **AD (Aggregate Demand Curve):** Represented in blue, this curve slopes downwards from left to right. - **AS (Short-run Aggregate Supply Curve):** Represented in orange, this curve slopes upwards from left to right.- **Equilibrium Point:** Where the AD and AS curves intersect, indicating the equilibrium price level and Real GDP at full employment.Below the graph are controls for adjusting the position of the AD and AS curves to show the effects of long-run expansionary monetary policy.## InstructionsAdjust the graph to show the **long-run effect** of an unanticipated **expansionary** monetary policy on the goods and services market by dragging the aggregate demand (AD) curve, the short-run aggregate supply (AS) curve, or both. **Adjust the graph to show the long-run effect of an unanticipated expansionary monetary policy on the goods and services market by dragging the aggregate demand (AD) curve, the short-run aggregate supply (AS) curve, or both.****Graph Explanation:**- The graph is titled "The Market for Goods and Services."- It has two axes: the vertical axis represents the price level and the horizontal axis represents real GDP.- There are two curves: - The Aggregate Demand (AD) curve is downward sloping, shown in blue. - The Aggregate Supply (AS) curve is upward sloping, shown in orange.- The intersection of the AD and AS curves indicates the equilibrium in the market.**Additional Information:**- A slider is available to adjust the AD curve and a separate one for the AS curve to reflect their possible shifts.**Exercise:**An expansionary monetary policy when the economy is at full employment leads to a [dropdown] [increase/decrease] in real GDP and a [dropdown] [increase/decrease] in the price level.**True or False Question:**In the long run, an expansionary monetary policy will cause real interest rates to fall.- [ ] True- [ ] False

Monetary Policy is a macroeconomic stabilization policy that is used by the central bank of a country to achieve the objectives of price stabilization, economic stability and economic growth. It is imposed to control the supply of money or the interest rates or the excess reserves. The quantity theory of money establishes the direct relation between the quantity or supply of money and the price level of an economy. According to this theory, in the long run, an increase in the money supply will cause a simultaneous increase in the price level as well.The formula to measure the money supply by using the equation of exchange in growth percentage terms is: %∆M+%∆V=%∆P+%∆Q where ∆M represents the change in money supply, ∆V represents the change in the velocity of money, ∆P represents the change in the price level, and ∆Q represents the change in real GDP. Determining the growth rate of real GDP when the growth of money supply is 4% and the growth in price level and the velocity of money are 0 each: 4%+0=0+%∆Q%∆Q=4% Hence, the real GDP would have to grow by 4%.An unanticipated expansionary monetary policy implies that there will be an increase in the money supply in an economy. As the money supply rises, there will be more loanable funds available to be supplied at each rate of interest. With the demand for loanable funds remaining unchanged, an increase in the supply of loanable funds curve will cause a fall in the equilibrium interest rates. Thus, the supply of loanable funds would increase leading to a decrease in short-term interest rates.An unanticipated expansionary monetary policy shifts the AD curve to the right as the decline in the short-term interest rates will raise the investment demand in the economy. As investment increases, the aggregate demand will also rise, which is represented as a rightward shift of the AD curve. The impact of an unanticipated expansionary monetary policy on aggregate demand is illustrated as follows: A rightwards shift of the aggregate demand curve from AD1 to AD2 curve will cause a temporary rise in the real GDP from Y1 to Y2 and a permanent rise in the price level from P1 to P2. The real GDP has risen temporarily because, in the long run, the GDP will converge back to its full employment level. For this to happen, the AS will shift backwards. Hence, the price level may be even set at a higher level than P2. Hence, an expansionary monetary policy at the full employment level causes a temporary increase in the real GDP and a permanent increase in the price level.An expansionary monetary policy shifts the LM curve towards the right from LM1 to LM2. With the IS curve remaining unchanged, an increase in the LM curve causes the interest rate to fall in the long run. Thus, the given statement is TRUE.

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6. Monetary policy in the long run Consider a hypothetical economy that produces at its long-run macroeconomic equilibrium at a price level of 100. Suppose that the central bank in this economy is expanding the money supply by 4% each year. In order for the price level to be maintained at 100, real GDP must grow at an annual rate of % if the velocity of money remains constant. Suppose the central bank enacts an unanticipated expansionary monetary policy. As a result, the supply of loanable funds , leading to in short-term interest rates. The following graph shows the goods and services market of this economy at full employment. Assume that potential output remains constant.

6. Monetary policy in the long run Consider a hypothetical economy that produces at its long-run macroeconomic equilibrium at a price level of 100. Suppose that the central bank in this economy is expanding the money supply by 4% each year. In order for the price level to be maintained at 100, real GDP must grow at an annual rate of % if the velocity of money remains constant. Suppose the central bank enacts an unanticipated expansionary monetary policy. As a result, the supply of loanable funds , leading to in short-term interest rates. The following graph shows the goods and services market of this economy at full employment. Assume that potential output remains constant.

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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4. When a Central Bank takes action to decrease the money supply and increase the interest rate, it is following a) a quantitative easing policy. b) a expansionary monetary policy. c) a contractionary monetary policy. d) a loose monetary policy.
5. Consider the following alternative scenarios for the country of Hibernia. Scenario A – Hibernia's central bank carries out a monetary policy that delivers a stable 2 percent inflation rate per year, on average, over twenty years. Scenario B– Hibernia’s central bank carries out a monetary policy that delivers highly variable 10 percent inflation rate per year, on average, over twenty years. Assume that Hibernia’s economy grows over time and consider the long-term impacts on the economy over time. Use the AD-AS graphical analysis, to illustrate the two scenarios. Hint consider the discussion on the costs of inflation earlier in the class – how can you incorporate this into your analysis?
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51) What is the impact on interest rates when the Federal Reserve decreases the money supply by selling bonds to the public? 52) Use demand and supply analysis to explain why an expectation of Fed rate hikes would cause Treasury prices to fall. 5.4 Supply and Demand in the Market for Money: The Liquidity Preference Framework 1) In Keynes's liquidity preference framework, individuals are assumed to hold their wealth intwo forms: A) real assets and financial assets. B) stocks and bonds. C) money and bonds. D) money and gold. 2) In Keynes's liquidity preference framework, A) the demand for bonds must equal the supply of money. B) the demand for money must equal the supply of bonds. C) an excess demand of bonds implies an excess demand for money. D) an excess supply of bonds implies an excess demand for money. 3) In Keynes's liquidity preference framework, if there is excess demand for money, there is…
7) Assume that the economy is initially operating at the natural level of output. A simultaneous expansionary monetary policy and an increase in oil prices will cause which of the following? A) an increase in output and a reduction in the interest rate in the short run B) a reduction in output and an increase in the interest rate in the short run C) a reduction in output and a reduction in the interest rate in the short run D) an ambiguous effect in output and an increase in the price level in the short run E) an ambiguous effect in output and a reduction in the price level in the short run
53) Which of the following statements about the ripple effects of monetary policy is FALSE? Monetary policy can Select one: a. raise the federal funds rate and shift the aggregate demand curve leftward. raise the federal funds rate, thereby raising the real interest rate and increasing potential GDP. c. raise the federal funds rate, thereby decreasing the quantity of money, raising the real interest rate, and decreasing investment.
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4. A common rule used for describing the conduct of monetary policy is the Taylor π = r + 0.5 (²-³) + 0.5(π — ñ), where r is the real rate of rule, given by i interest and it is a target rate of inflation. Assume that the real interest rate at full employment to be constant at 2%. Assume also that the same 2% represents target inflation. a. What is the nominal interest rate i when inflation and output are at their equilibrium target level? b. Suppose that the central bank observes a rate of inflation of 4%. With all other variables at the same level. What is the nominal interest rate the central bank would target according to the Taylor rule?
5. The slope and position of the long-run aggregate supply curve Suppose the Fed doubles the growth rate of the quantity of money in the economy. In the long run, the increase in money growth will change which of the following? Check all that apply. n The level of technological knowledge n The quantity of physical capital The inflation rate n The size of the labor force Suppose the economy produces real GDP of $50 billion when unemployment is at its natural rate. Use the purple points (diamond symbol) to plot the economy's long-run aggregate supply (LRAS) curve on the graph. 132 128 LRAS 124 120 116 112 108 104 100 10 20 30 40 50 60 70 80 OUTPUT (Billions of dollars) Suppose the government passes a law that significantly increases the minimum wage. The policy will cause the natural rate of unemployment to which will: o Not affect the long-run aggregate supply curve o Shift the long-run aggregate supply curve to the left o Shift the long-run aggregate supply curve to the right In the…
7. Consider the money market. Suppose the U.S. economy begins to boom and aggregate output increases. Describe the effect on the interest rate if the Federal Reserve decides to increase the money supply at the same time that aggregate output increases.
8. Macroeconomic factors that influence interest rate levels Apart from risk components, several macroeconomic factors—such as Federal Reserve (the Fed) policy, federal budget deficit or surplus, international factors, and levels of business activity—influence interest rates. Based on your understanding of the impact of macroeconomic factors, identify which of the following statements are true or false: Statements True False When the Fed increases the money supply, short-term interest rates tend to decline. Actions that lower short-term interest rates will always lower long-term interest rates. Long-term interest rates are not as sensitive to booms and recessions as are short-term interest rates. The Federal Reserve’s ability to use monetary policy to control economic activity in the United States is limited because US interest rates are highly dependent on interest rates in other parts of the world.