Question

suppose the fed reduces the money supply by 4 percent. assume the velocity of money (v) is constant.
a. what happens to the aggregate demand (ad) curve?
the ad curve shifts to the left.
b. what happens to output and the price level in the short run and long run? give precise numerical answers.
in the short run, the price level decreases by percent.
c. in the short run, output decreases by percent.
d. in the long run, output will ultimately decrease by percent.
e. in the long run, the price level will decrease by percent.
f. consider your answers to the above questions. what happens to unemployment in the short run and in the long run, according to okuns law? round your answer to one decimal place, if possible.
in the short run, unemployment increases by percent.
g. in the long run, unemployment increases by percent.

Explanation:

Step1: Quantity Theory of Money ($MV = PY$)

In the short - run, assume velocity ($V$) is constant. When the Fed reduces the money supply ($M$) by 4 percent, the aggregate demand ($AD$) curve shifts left. In the short - run, prices ($P$) are sticky. So, $M\downarrow = Y\downarrow$. Since $M$ decreases by 4%, output ($Y$) decreases by 4% in the short - run.

Step2: Short - run price level

Since prices are sticky in the short - run, the decrease in the price level is \(0\%\) in the short - run.

Step3: Long - run analysis

In the long - run, output ($Y$) is at the natural level (determined by factors of production and technology). So, $M\downarrow = P\downarrow$. Since $M$ decreases by 4%, the price level ($P$) decreases by 4% in the long - run and output is unchanged (\(0\%\) change).

Step4: Okun's Law ($\Delta u=-\frac{1}{2}\Delta Y$)

In the short - run, $\Delta Y=- 4\%$. Using Okun's Law $\Delta u =-\frac{1}{2}\times(-4\%) = 2\%$. In the long - run, $\Delta Y = 0\%$, so $\Delta u=0\%$.

Answer:

• In the short run, the price level decreases by \(0\) percent.
• In the short run, output decreases by \(4\) percent.
• In the long run, output will ultimately decrease by \(0\) percent.
• In the long run, the price level will decrease by \(4\) percent.
• In the short run, unemployment increases by \(2\) percent.
• In the long run, unemployment increases by \(0\) percent.