Question

Assume an economy in a long run equilibrium with real GDP equal to potential output. Now suppose the bank of canada decreases the money supply . Use a graph to show and briefly state how this impacts interest rate , real GDP and the price level in the short run. What kind of gap is created in economy ? And also show and explain the economy can return to potential GDP in long run.

Answer 1

During the long run, potential and real GDP tend to be same as total spending. This implies that during long run, price level need to be at position where aggregate supply and demand intersect. The interest rates usually increase in such cases as well as the price level.