detailed answers please Figure 1 An conomy in long nun equil

detailed answers please

Figure 1: An conomy in long nun equilibrium Inflation LRAS Rate AS AD Aggregate output

Solution

Solution:

(a) At point 1, AD = AS

AS curve is pi = 2 + 1.5(Y - 10) = 1.5Y - 13; which can also be written as Y = (pi + 13)/1.5

So, at point 1, AD =AS implies, 11 - 0.5*pi = (pi + 13)/1.5

16.5 - 0.75*pi = pi + 13

16.5 - 13 = (1+0.75)pi So, pi = 3.5/1.75 = 2

(b) If autonomous spending increases by 2, new AD curve is Y = (11 - 0.5*pi) + 2

Y = 13 - 0.5*pi

With MPC = 0.5, multiplier in the economy = 1/(1 - MPC) = 1/(1 - 0.5) = 2

Thus, AD curve will shift rightwards (It is a parallel rightward shit, you can also verify this by drawing the new AD curve)

(c) Again, at point 2, equilibrium occurs where AD2 = AS1 (AD2 refers to the new AD curve)

So, 13 - 0.5*pi = (pi + 13)/1.5

19.5 - 0.75*pi = pi + 13, on solving this, we get pi = 3.714 (approx)

So, using AD curve (or AS curve may also be used), Y = 13 - 0.5*3.714 = 11.143

(d) As we have seen above, such increase in autonomous spending will increase the inflation rate ( from 2 to 3.714), and real GDP or Y (from 10 to 11.143). This real output greater than it\'s natural level of output is temporary. As the inflation rate rises, and nominal wages remain same, the purchasing power of the workers decrease. Hence, to retain the purchasing power, there will be a push to increase nominal wages, and thus firms will cut the production (because it has to undergo higher costs due to employing workers by giving them higher nominal wages). So, this cut in production reduces aggregate supply, shifting the aggregate supply (AS) curve to the left, and this long run-equilibrium is retained (where output reached back to it\'s natural level (same as the old one, i.e, 10) and inflation rate has increased, higher than 3.714).