Determine the Outcomes of Specific Economic Situations
Core Concepts
You must predict outcomes of policy actions and external shocks using the AS/AD model, money market, and loanable funds market. Key tools: monetary policy (central bank actions), fiscal policy (government spending and taxes), open-market operations, discount rate, reserve requirements, interest rates, and exchange rates.
Outcomes to Determine
- Expansionary monetary policy: Central bank buys bonds → money supply increases → interest rates fall → investment and consumption rise → AD shifts right → real GDP rises, unemployment falls, price level rises.
- Contractionary fiscal policy: Government spending falls or taxes rise → AD shifts left → real GDP falls, unemployment rises, price level falls (or inflation slows).
- Supply-side shocks: e.g., oil price spike → SRAS left → stagflation.
- Exchange rate effects: Higher domestic interest rates attract foreign capital → currency appreciates → net exports fall.
Common Traps
- Mixing up the direction of open-market operations: buying bonds increases reserves and money supply; selling decreases.
- Forgetting lags: policy effects are not instantaneous.
- Assuming fiscal policy always shifts AD by the full multiplier; crowding out may reduce it.
- Ignoring the difference between nominal and real interest rates (Fisher effect).
Worked Example
The central bank conducts an open-market purchase of $100 million. With a reserve requirement of 10%, the money multiplier is 1/0.10 = 10, so the money supply can increase by up to $1 billion. This lowers interest rates, stimulating investment and shifting AD right. In the short run, real GDP rises and unemployment falls; in the long run, price level rises.
Rule of thumb: Trace the chain: policy tool → money supply/interest rate → components of AD → equilibrium output and price level.