Problem 13

1. Consider a closed economy which output is above the natural rate of output.

a) Illustrate the current state of the economy using an AD-AS diagram. Suppose the government were to decide to permit the economy to return to long run equilibrium on its own. Describe the adjustment process including any changes to consumption and investment.

b) Suppose the Fed decides to use monetary policy (an open market operation) to bring the economy back to the natural level of output. State whether the Fed engages in an open market purchase or sale and illustrate this policy and its effects on the AD-AS and the Money Market diagrams below. [You should first draw in the lines you drew in parts (a) and (b).]

P

Y

AD

LRAS

Ybar

C) How does this monetary policy affect the long run equilibrium level of output, the price level, the real interest rate and the composition of output? [For the composition of output, state which direction do consumption, investment, and government expenditure change and explain why these changes occur.]

Money Demand

P

Y

r S0

M

AD0

LRAS

Ybar

r0

r1