Question

In the short run, the quantity of output that firms supply can deviate from the natural level of output if the actual price level in the economy deviates from the expected price level. Several theories explain how this might happen.

For example, the sticky-price theory asserts that the output prices of some goods and services adjust slowly to changes in the price level. Suppose firms announce the prices for their products in advance, based on an expected price level of 100 for the coming year. Many of the firms sell their goods through catalogs and face high costs of reprinting if they change prices. The actual price level turns out to be 90. Faced with high menu costs, the firms that rely on catalog sales choose not to adjust their prices. Sales from catalogs will ? , and firms that rely on catalogs will respond by ? the quantity of output they supply. If enough firms face high costs of adjusting prices, the unexpected decrease in the price level causes the quantity of output supplied to ? the natural level of output in the short run.

Suppose the economy's short-run aggregate supply (AS) curve is given by the following equation:

Quantity of Output SuppliedQuantity of Output Supplied

=  =

Natural Level of Output+α×(Price LevelActual−Price LevelExpected)Natural Level of Output+α×Price LevelActual−Price LevelExpected

The Greek letter αα represents a number that determines how much output responds to unexpected changes in the price level. In this case, assume that α=$2 billionα=$2 billion. That is, when the actual price level exceeds the expected price level by 1, the quantity of output supplied will exceed the natural level of output by $2 billion.

Suppose the natural level of output is $60 billion of real GDP and that people expect a price level of 100.

On the following graph, use the purple line (diamond symbol) to plot this economy's long-run aggregate supply (LRAS) curve. Then use the orange line segments (square symbol) to plot the economy's short-run aggregate supply (AS) curve at each of the following price levels  90, 95, 100, 105,

Y- PRICE LEVEL: 125 120 115 110 105 100 95 90 85 80 75

X- OUTPUT (Billions of dollars) : 10 20 30 40 50 60 70 80 90 100

The short-run quantity of output supplied by firms will fall below the natural level of output when the actual price level ? the price level that people expected.

Answer 1

Sticky Price theory:

sticky-price theory asserts that the output prices of some goods and services adjust slowly to changes in the price level. Suppose firms announce the prices for their products in advance, based on an expected price level of 100 for the coming year. Many of the firms sell their goods through catalogs and face high costs of reprinting if they change prices. The actual price level turns out to be 90. Faced with high menu costs, the firms that rely on catalog sales choose not to adjust their prices. Sales from catalogs will FALL, and firms that rely on catalogs will respond by REDUCING the quantity of output they supply. If enough firms face high costs of adjusting prices, the unexpected decrease in the price level causes the quantity of output supplied to FALL BELOW the natural rate of output in the short run.

Short run aggregate supply run equation:

Quantity of Output Supplied = Natural Level of Output + α x (Price Level (actual) - Price level (expected))

α = $2 billion

Natural level of output = $60 billion of real GDP

People expect a price level of 100

Natural Output	α	Price level (actual)	Price Level (expected)	α(Actual price - Expected price)	Output supplied
60	2	90	100	-20	40
60	2	95	100	-10	50
60	2	100	100	0	60
60	2	105	100	10	70

Note: The LRAS represents the natural level of output

The short run quantity of output supplied by firms will fall below the natural level of output when the actual price level lower than the price level that people expected.