Question

Unlike aggregate demand, we distinguish between short-run and long-run aggregate supply. Short-run aggregate supply (SRAS) is a horizontal curve whereas long-run aggregate supply (LRAS) is vertical.

a.) In our model of aggregate supply and demand, we distinguish between short-run and long-run aggregate supply. In the short run, what variable can firms adjust and what variable is fixed? In the long run?

b.) Plot the short-run aggregate supply curve, the long-run aggregate supply curve, and the aggregate demand curve below. Label the y- and x-axes.

c.) Suppose the Federal Reserve expands the money supply. In the short run, what is the impact on aggregate demand? Show on your graph above. What happens to the price level and to output in the short run?

d.) In the long run, firms adjust to the new money supply. What effect does this have on output and prices? Show on your graph above.

PLEASE SHOW WORK AND ANSWER ALL PARTS. THANK YOU

Answer 1

a) LRAS is a vertical curve while SRAS is an upward sloping curve. This is because of sticky wages i.e. wages do not adjust with the price level in short run, so, unemployment rate can be more than or less than the natural rate of unemployment but in long run wages adjusts with the price level, so, unemployment rate is at natural rate only and unemployment rate doesn’t change in long run. The shifts in LRAS can only be due to the factors that can affect the productivity in long run but temporary changes can change the SRAS.

c) An increase in money supply will lead to a decrease in interest rate reducing the borrowing cost, so, this induces investment and consumption increasing the aggregate demand shifting it rightwards from AD to AD’. This will create a situation of excess demand in the market which will lead to increase in price level from P to P’. This increase in price level leads to increase in quantity supplied causing output to increase from Y to Y’.

d) In long run, this increase in prices leads to fall in real wages of the workers, who will demand more wages increasing the cost of production of the firms who in response will decrease the aggregate supply shifting it from SRAS to SRAS’. This will increase prices further to P” and output will decrease to the level Y.

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