Central Bank Tightening
The question
Assume the economy of Halvane is initially in long-run equilibrium. Worried about rising inflation, the central bank of Halvane sells a large quantity of government bonds on the open market, and interest rates throughout Halvane rise. Show the short-run effect of this action on Halvane's economy, holding all else constant. Show the effect on the AD-AS Model graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Central Bank Tightening: the worked answer
On the AD-AS Model graph, AD shifts left.
Why AD shifts left
An open-market sale drains reserves from the banking system and pushes interest rates up. Higher borrowing costs lead firms to undertake less investment spending and lead households to buy fewer interest-sensitive goods such as cars and houses, so total spending at every price level falls and aggregate demand shifts to the left. Nothing in the action changes firms' per-unit production costs, so short-run aggregate supply does not move, and the economy's resources and technology are unchanged, so long-run aggregate supply stays put.
What happens to the equilibrium
The equilibrium price level falls and real GDP declines below full-employment output in the short run.
The mistake students make on this one
A frequent error is shifting SRAS left because higher interest rates feel like a cost to firms. In the AP model interest on borrowing is not part of the per-unit cost of producing output; monetary policy reaches the economy through interest-sensitive spending, so it lands on AD.
On exam day
Both monetary and fiscal policy act on AD in this model, so reserve SRAS for events that change the cost of producing one unit: wages, input prices, productivity, and per-unit business taxes or subsidies.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when AD shifts left and every other curve on the AD-AS Model graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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