Problem 2: Monetary Policy in the AD-AS Model [18 Points]
Suppose that an economy begins in Long-Run Equilibrium, in both Real GDP (Y) and in the Market
for Money (M). Now suppose that there was a shock that there was an increase in the wage rate.
Suppose also that the Central Bank is targeting the interest rate directly.
[Note: an increase in the wage rate should not shift AD at all, because AD already captures the
effect of a certain national income (Y). If wages went up, but income did not change, there would
be no reason to expect a change in consumer consumption behaviour.]
6. [2 points] What would we expect to happen to the price level (p) and Real GDP (Y) in the
Short-Run? Explain your answer using a figure with AS and AD.
7. [3 points] What would happen to the Money Market in the Short-Run? Would it stay in
equilibrium or enter a surplus or shortage? Explain your answer using a figure with MS
and MD.
8. [2 points] If the Central Bank wants to return the price level to its original level (where it
started) in the long-run, then what should it do? Explain your answer using a figure with
AS and AD.
9. [3 points] If the Central Bank wants to keep the price level stable at its current short-run
level (after wages went up) in the long-run, then what should it do? Explain your answer
using a figure with AS and AD.
Suppose that the Government is concerned with trying to prevent wage decreases in the
economy.
10. [2 points] If the government wants to prevent wage decreases, should it intervene or
should it not intervene? Explain your answer using a figure with AS and AD.
11. [3 points] If the government chooses to intervene and closes the current output gap, what
will happen to Money Demand (MD)? What does the Central Bank have to do to the
Money Supply (MS) to maintain equilibrium in the Money Market? Explain your answer
using a figure with AS and AD and with a figure with MS and MD.
Suppose that the Central Government (in charge of fiscal policy) was trying to maintain stability
in Y. Suppose also that the Central Bank is interested in trying to maintain stability in p.
12. [3 points] Would these two arms of government agree or disagree on which actions to
take in response to this wage shock? Explain which actions each would want to take?
