Question

Use the following information for the next 7 questions. You should draw a graph that depicts the situation below and use your picture to answer the questions. Assume that wages and prices are sticky and that we start at a long-run equilibrium. Assume that at this initial point, the growth rate of the money supply is 5%, the growth rate of the velocity of money is 2% and that the real economic growth rate is 4%. Now assume that there is a negative real shock. After the negative real shock, the inflation rate in the economy is 9%. Now assume that the federal government decides to increase government spending in order to combat the situation resulting from the rise in oil prices. After the increase in government spending, the growth rate of the velocity of money is 8%.

What is the inflation rate at the initial long-run equilibrium (the point where we start)?

The negative real shock causes the _______ curve to shift _______.

After the negative real shock (Point 2), what is the level of expected inflation for the SRAS curve?

After the negative real shock (Point 2), what is the the real economic growth rate?

When the federal government decides to increase government spending, the ______ curve shifts ______.

After the federal government increases government spending (Point 3), what is the growth rate of the money supply?

After the federal government increases government spending (Point 3), what is the inflation rate in your graph?

Answer 1

Answer:-
Here is the economy that starts at a long-run equilibrium. This implies that the LRAS, SRAS and AD all intersect two determine the inflation rate and GDP growth rate.
At this initial point, the growth rate of the money supply is 4%, the growth rate of the velocity of money is 3% and that the real economic growth rate is 5%.
The quantity theory of money indicates that MV = PY. This also implies that any percentage change in any of the variable affects the whole equation:
%? in M + %? in V = %? in P + %? in Y
Given the variables, we have the following inflation rate at the initial level
4 + 3 = %? in P + 5
%? in P = 7 – 5 = 2%
This implies that initial inflation rate is 2%.
Now assume that there is a negative real shock. After the negative real shock, the inflation rate in the economy is 7%. A negative real shock shifts the LRAS and SRAS to the left. There is no change in growth rate of money supply or velocity of money so that inflation reduces the real growth rate:
%? in M + %? in V = %? in P + %? in Y
4 + 3 = 7 + %? in Y
%? in Y = 0
Hence, the growth rate of GDP falls to zero. Government wishes to restore original equilibrium so that the growth rate of GDP comes back from 0% to 5%. To do this, the federal government decides to increase government spending in order to combat the situation resulting from the rise in oil prices. After the increase in government spending, the growth rate of the velocity of money is 8%.
In the given figure, AD is drawn for a constant spending growth rate (+). Therefore, any change in the AD that shifts AD to the right (increase in government spending) must be pushing the money supply or velocity up
Given the value of =4%, value of growth of velocity rises from 3% to 8% so that the value of+increases to 12%. But this growth is insufficient since the size of shift of AD must be greater than 5% to increase GDP growth rate by 5%. This suggests that if velocity increases only by 8%, then money supply must increase in order to restore the equilibrium.
At the new equilibrium level, velocity is growing by 8%, money supply is growing by 11%, so that this step by the government increases the real GDP growth as:
%? in M + %? in V = %? in P + %? in Y
11 + 8 = %? in P + 5
%? in P = 14%
Now we have the answers to the questions.
1. What is the inflation rate at the initial long-run equilibrium (the point where we start)?
Inflation is 2 percent in the beginning.
2. After the negative real shock (Point 2), what is the level of expected inflation for the SRAS curve?
It is adjusted to 7% since people change their expectations
3. After the negative real shock (Point 2), what is the real economic growth rate?
It has fallen down to 0 percent
4. After the federal government increases government spending (Point 3), what is the growth rate of the money supply?
It increases from 4% to 11%.
5. After the federal government increases government spending (Point 3), what is the inflation rate in your graph?
The new inflation rate is 14 percent.