Question

Consider an economy described by the following short-run aggregate demand, aggregate supply and long-run aggregate supply curve:

(short-run aggregate demand curve) P = 200 – Y

(short-run aggregate supply curve) P = 40 + Y

(long-run aggregate supply curve) Y *= 120

where P = Price Level (price index with base period’s index = 100) and Y = Quantity of Output

1. Draw a diagram below to show equilibrium with P on Y-axis and Y on X-axis by finding equilibrium price level (P*) and output level (Y*):     P*=_____________ Y* =___________

2. Suppose there is an oil crisis caused by OPEC all firms costs are increased. The new short-run aggregate supply curve becomes: P= 50 + Y

Find new equilibrium price (P**) and output level (Y**):                                  P**=_____________ Y **=____________

3. Draw the new Aggregate Supply curve on Diagram (1) and mark both P** and Y**

3. The following statement describes new equilibrium in (2): Fill in the parenthesis with appropriate keywords from keywords below:

The output of the economy falls from Y* to Y** falling output experiencing ( a)______________

And the price level rises from P* to P** experiencing (b)________________, such an event is called (c)__________________. According to the (d)_______________ theory, the key issue is how nominal wages are affected by price changes.

Key words: (1) full employment (2) stagflation (3) inflation (4) deflation (5) unemployment

5. wage-price spiral (7) sticky-wage (8) sticky-price

Answer 1

The short run aggregate supply curve(SRAS)= P=40+Y

Short run aggregate demand curve (SRAD)= P= 200- Y

Long run aggregate supply curve(LRAS)Y*=120

The equilibrium is at the intersection of the SRAS and SRAD curve.

At equilibrium, SRAD= SRAS

200-Y= 40+Y

200-40= Y+Y

160= 2Y

Y= 80

Substitute the value of Y in either the SRAS or SRAD equation.

P= 40+80= 120

Thus, the equilibrium price(P*) is 120 and equilibrium output (Y*) is 80.

An oil crisis caused by OPEC leads to increase in costs. This causes the aggregate supply to fall and shift leftwards. This is shown by a shift from SRAS1 to SRAS2 in the graph.

SRAS2= P= 50+Y

The new equilibrium is at the point where SRAD and SRAS2 intersect.

200-Y= 50+Y

200-50= Y+Y

150=2Y

Y= 75

Substituting the value of Y to get P

P= 50+ 75

P= 125

The new equilibrium price(P**)= 125

Equilibrium output (Y**)= 75

The output of the economy falls from Y* to Y** falling output experiencing ( a) unemployment

And the price level rises from P* to P** experiencing (b) inflation, such an event is called (c) stagflation. According to the (d)sticky- wage theory, the key issue is how nominal wages are affected by price changes.