Question

(32 marks total) Consider the AD-AS model of chapter 9, with the AD curve derived from the quantity theory of money. Suppose the economy is initially in long-run equilibrium, when there is a sudden rise in demand for real balances for any given level of output, and simultaneously also an improvement in productive technology that permanently increases how much firms can produce with any given amount of the factors of production. (a) Immediately following these shocks, what happens to velocity? To the AD curve? The LRAS curve? The SRAS curve? (b) Show the initial AD, LRAS and SRAS curves in a graph, and then show how each curve shifts (if at all) in the short run in response to the above shocks. (c) Explain what happens to the amount of labour firms employ L, output Y , and the price level P upon arrival of these shocks (i.e., in the short run). In the graph you drew in part (b), show the short-run equilibrium combination of Y and P. (d) In the long run, assuming no further changes in AD, what must happen to L, Y , and P? Show the new long-run equilibrium in the graph you drew in part (b). (e) Explain in words how and why the economy transitions from the short-run equilibrium to the long-run equilibrium. Be sure to explain the role that firms’ motivations play in this transition.(f) Suppose the central bank wishes to have Y be at its long-run level at all times. What policy should it enact in response to the shocks? Show in a graph how this policy works. How does the magnitude of the policy change compare with what would have been necessary if only one of the shocks had hit this economy? (g) Suppose the central bank wishes to have P return eventually to its pre-shock level. What policy should it follow in response to the shock? How, if at all, is this policy different from the one you found in part (f)? Based on your answer, does the central bank face any trade-off between stabilizing short-run output and stabilizing long-run prices in response to shocks of this sort?

Answer 1

AD curve shifts to the right due to increase in demand

As curve shift to the right due to increase in productivity.

LRAS curve dont shift on short run

b) Fig 1 Show the initial AD, LRAS and SRAS curves in a graph

Fig 2 shows show how each curve shifts in the short run in response to the above shocks

C) Amount of Labor and output in the economy increases in short run. Nothing can be said about price in short run it depends upon amount of change is demand and supply curve.

In fig 2, Output increases from Y to Y1 upon arrival of shocks in the economy in short run

D) In the long run, output increases, while the Level of labor and price remain the same. Economy runs in full employment.

e) In the long run is the period when the general price level, contractual wage rates, and expectations adjust fully to the state of the economy, in contrast to the short run when these variables may not fully adjust

Firms transition from short run to long run because in long run is there are no fixed factors of production, so that there are no constraints preventing changing the output level by changing the capital stock or by entering or leaving an industry. While in short run, some factors are variable and others are fixed, constraining entry or exit from an industry.

f) the central bank wishes to have Y be at its long-run level at all times Central Government will increase the money supply by decreasing the interest rate. It will increase the demand for goods and services, thus Y will remain high.

If supply of money increases from s1 to s2 interest rate come down from r1 to r2. There is less incentive to save and consumption increases. With more money in economy demand for goods and services goes up.

If only demand would have increased than this policy lead to inflation.

If only supply would have increased both output and price increase.

g) the central bank wishes to have P return eventually to its pre-shock level then it should decrease the money supply by increasing interest rate.

the central bank face any trade-off between stabilizing short-run output and stabilizing long-run prices in response to shocks of this sort because in short run, If it will adopt expansionary policy, it may lead to inflation and in long run if it will adopt contractionary policy it could reduce output or GDP