00:01
Use the is -lm model to graphically illustrate how the economy will adjust in the long run if no policy action is taken if the economy is initially in a short -run equilibrium at a level of output below the natural rate.
00:26
So let's draw out our is and lm curves.
00:29
So we have interest rate at output and then we have our is and lm curve and then this is our long -run aggregate supply curve.
00:51
So when the economy is running at a lower level than the natural rate of employment or potential output, the economy is in recession.
01:06
There are unemployed and underemployed workers.
01:10
Then we need to look at the short -run equilibrium point of the economy.
01:16
So we will look at where these two curves cross.
01:20
This is the short -run equilibrium point.
01:29
So then we can get the short -run equilibrium gdp and the potential level of output.
01:41
So this is the potential level of output and then in the short -run equilibrium this is our actual output and this is below the natural rate.
02:34
Then without any policy intervention it's going to reach the potential level of output in the long run.
03:03
So basically what happens is our lm curve is going to shift to the right reaching our potential output at yp.
03:24
So this is because due to higher unemployment workers will be ready to work for lower wages increasing employment and reducing production costs.
03:33
And then the producers will reduce the price level due to lower demand and lower production costs.
04:09
This then reduces the inflation level which increases the real money supply which decreases interest rates and boosts spending increasing output.
04:31
So these two things cause the lm curve to shift to the right and that's how the economy adjusts in the long run with no policy.
04:45
So in summary in long run the lm curve is going to shift to the right because of an increased money supply.
05:11
So then the next part asks us what is the long -run equilibrium if fiscal policy is used to return the economy to the natural rate of output...