Question

The table below gives a numerical example of an aggregate demand curve.

Real GDP (percent deviation from potential GDP) 3 2 1 0 -1 -2 -3

Inflation (percent per year) 1 1.5 2 3 4 6 9

1.Sketch the curve in a graph.

2.What is the average rate of inflation in the long run?

3.Suppose that the central bank shifts policy so that the average rate of inflation in the long run is 2 percentage points higher than in (b). Sketch a new aggregate demand curve corresponding to the higher inflation rate.

Answer 1

Consider the following fig where we have measure “Y = real GDP” on the horizontal axis and “P= inflation rate” on the vertical axis.

So, here “P1” be the initial rate of inflation and the blue line be the AD curve here.

2).

Here the average rate of inflation is “P=3” where “Y=0” in the LR. Since here “Y” shows the percentage deviation from potential GDP, => in the LR “Y” should be “0”, => actual GDP should be same as potential GDP, => percentage deviation should be “0”, => “Y=0”.

3).

Now, suppose the average rate of inflation is 2 percentage higher than “2”, => Consider the above table and fig, where “P2” be the new rate of inflation which is 2 percentage higher than the initial one “P1” and “the red line be the new “AD” curve. So, for "Y=0" the "P2=5" which is 2 percentage higher than the initial one.