Question

Consider the aggregate demand/aggregate supply model of Chapter 10. Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = 2. The aggregate demand curve is given by Y = MV(1/P), with M = 6,000 and V=1.

a) Suppose that there is an adverse supply shock that shifts the short-run supply curve upwards, to P = 3. What are the values of P and Y in the short-run equilibrium after this shock?

b) What changes (if any) in the values of P and Y would take place going from the short-run equilibrium of part A to the long run (assuming no other shocks occur)?

c) If the FED wants to avoid any changes in the level of Y as a response to the supply shock, what should be the change in the quantity of money M?

Answer 1

Question a)

suppose adverse supply shock shifts SRAS from P=2 to P=3

Before shock

This is the long run equilibrium

After shock

Short run equilibrium after shock is at Y=2000 and P=3

Question b)

The P in the long-run will be 2 and the Y in the long-run will be 3000. Short-run equilibrium (Y=2000,P=3) will tend to adjust toward the long-run equilibrium as the economy has time to recover from the supply shock.

Question c)

If the FED wants to avoid any changes in the level of Y as a response to the supply shock

taking price level after shock, P=3 and the long run output level Y=3000

As a response to supply shock, FED should increase the money supply by 3000 from 6000 to 9000 in order to keep the output at long run level of 3000 with price level equal to 3