Assignment 3, due April 1,before class 4:30PM Please do the following exercise from
1. Chapter 9, Question 2
Suppose the Fed reduces the money supply by 5 percent.
a) What happens to the aggregate demand curve?
If the Fed reduces the money supply, the aggregate demand curve shifts down. According
to the equation MV = PY, a decrease in money M leads to a simultaneous decrease in
nominal output PY ( also assuming V is fixed). For any given price level P, the level of
output Y is lower, and for any given Y, P is lower.
b) What happens to the level of output and the price level in the short run and in the long
we assume that the price level is fixed and that the aggregate supply curve is flat.
Therefore, in the short run, output falls but the price level doesn’t change. In the longrun,
prices are flexible, and as prices fall over time, the economy returns to full employment.
we assume that velocity is constant, we can quantify the effect of the 5% reduction in the
ΔM/M + ΔV/V = ΔP/P + ΔY/Y
We know that in the short run, the price level is fixed. This implies that the percentage
change in prices is zero and thus ΔM/M = ΔY/Y. In the short run a 5 percent reduction in
the money supply leads to a 5 percent reduction in output.
In the longrun we know that prices are flexible and the economy returns to its natural
rate of output. This implies that in the longrun, the percentage change in output is zero
and thus ΔM/M = ΔP/P. Thus in the long run a 5 percent reduction in the money supply
leads to a 5 percent reduction in the price level.
c) According to Okun’s