Question

Within the AD-AS model, from a situation of medium-run equilibrium in all markets, the central bank decreases the monetary base. Analyse the short-run and medium-run effects on the relevant macroeconomic variables, describing in detail the adjustment process in the economy.

Answer 1

Monetary base is the money in hands of people and deposits with public. When central bank reduces monetary base, there is reduction in circulation of money in economy which will reduce the willingness to pay of individuals and results in fall in aggregate demand in the economy. Thus, in short run it will shift the demand curve to its left while keeping the aggregate supply curve to same level. It will reduce the prices from P to P1 and output level from Y to Y1.In medium run when producers get to know that there is less demand for there products, they will reduce the supply of them rather than building inventories of their products when there is less demand. It will also shift the supply curve to its left from AS to AS1. It will shift the economy from point A to B to C and raises the price to P and reduces the output level further to Y2.