Question

Please discuss the impact of monetary policy tightening with regards to both unemployment and inflation with respect to both the short run and long run?

Answer 1

Answer:

Explanation:

Monetary policy tightening decreases money supply and increases interest rate. Higher interest rate lowers investment, which will decrease aggregate demand. AD curve will shift to left, decreasing both price level and real GDP, giving rise to a recessionary gap in short run. Inflation will decrease and unemployment will increase.

In the long run, lower price level will decrease wages and prices of inputs, decreasing production costs. Firms will increase production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring real GDP to potential GDP GDP.

When aggregate demand falls, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap of (Y0 - Y1). In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0. Inflation will decrease and unemployment will decrease & restore to initial (full employment) level.