Question

1. 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

Answer:

Given that:

Consider the aggregate supply model of Chapter 10,Assume that the long-run aggregate supply curve is vertical at Y=3,000

long - run aggregate supply curve ,LRAS Y = 3000

Short - Run aggregate supply curve , SRAS P=2

Aggregate demand , AD

Y=MV* 1 / P

= MV / P

Money supply , M=6000

Velocity of money , V=1

a)

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

Before Shock

P=2

This is the long run equilibrium

After Shock

P=3

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

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 adjust toward the long-run equilibrium as the economy has time to recover from the supply shock.

As a response to supply ,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.

c)

If the 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