Question

Spartanville is a small country off the coast of Western Canada that relies heavily on the extraction of artisia, a cheap metal that is an input to production for many Spartanville products. This year, Spartanville has seen extended blizzard conditions followed by heavy flooding when the snow melted; making artisia nearly impossible to mine.

+Assume that the initial level of spending growth is 8%.

+Also assume that prior to the blizzards, Spartanville was at an equilibrium inflation rate of 4%.

13. What is the long run economic growth rate before the blizzards occurred?

14. In the New Keynesian model, what is the general effect on inflation, short run, and long run economic growth in this problem? Draw a (legible) diagram to show what happens if the Fed does not respond to the shock.

15. Assume the long run rate of growth fell to -1%. What is the new inflation rate if there is no change in velocity and no action by the Fed?

Answer 1

When there is impossible to mine due to heavy flood, aggregate supply in the economy will reduce and the curve of aggregate supply curve will shift backward.

Spending growth(nominal growth) is given as 8% and inflation is 4%.

The formula of Nominal GDP = Real GDP + Inflation rate

(13) Spending growth is always the nominal GDP because nominal GDP is always calculated in monetary terms. So we need to find here the economic growth which is real GDP which is by formula is 4%

(14) In Keynesian model we have Aggregate demand and supply given. In shirt run aggregate supply is upward sloping and aggregate demand is downward sloping, where ever they intersects there comes an equilibrium point which tells us the price and quantity level in short run.In long run, aggregate supply curve is vertical and aggregate demand curve is downward sloping. Thus when AS shifts to AS1 and AD remains the same. Prices shifts upward and output reduce to new level.

When aggregate supply shifts backwards which means there is is less supply in the economy. Fed will reduce interest rate here to increases the investment level which will eventually increase the supply level to the same level. If Fed do not participate in this scenario, prices will increase and inflation will only rise.

(15) If there is -1% of real growth level in the economy and there is no change in money supply in the economy. Then inflation level will be  9%.