Suppose the Fed reduces the money supply by 5 percent.
(a) What happens to the aggregate demand curve?
(b) What happens to the level of output and the price level in the short run and in the long run?
(c) According to Okun’s law, what happens to unemployment in the short run and in the long run?
(d) Now let’s be more quantitative. If the aggregate demand curve satisfies M s /P = (1/v)Y derive a formula relating the percentage changes of these variables. (Recall the percentage change in the product of X and Y is approximately the percentage change X plus the percentage change in Y.
(e) Assuming the velocity of money is constant, how much does Y fall by in the short run?
(f) Using the formula for Okun’s law, how much does unemployment rise by?
(g) What happens to the real interest rate in the short run and long run? (The model of chapter 3 is helpful in answering this question.)