Question

An economy has the following AD and AS curves:

AD curve: Y = 300+ 30 (M/P),

AS curve:   Y = Y_bar+(3/10) (P-P^e).

Here, Y_bar=500 and M=400. The economy has been in the long-run (full-employment) equilibrium for a long period of time. Then a negative supply shock decreases full employment output to Y_bar=318. This is a total surprise for the public. What will be the equilibrium price P?

A. 60

B. 120

C. 150

D. 200

Answer 1

AD Curve: Y = 300 + 30 (400/P)

AS Curve: Y = 500 + 3/10 (P-Pe)

At full employment level of output, the actual price level equals the expected price level

i.e., P = Pe

At Equilibrium,

AD = AS

300 + 30 (400/P) = 500 + 0.3 (0)

200 = 12000 /P

P= 12000/200

P = 60

Now, the negative supply shock moved the AS curve to the left reducing the full employemnt level of output to 318.

The new AS curve equation then becomes, Y = 318 + 3/10 (P-Pe)

Assume that Pe= 60

At Equilibrium,

300 + 30 (400/P) = 318 + 0.3 (P-60)

300 + 30* 400/P = 318 + 0.3 P - 18

12000/P = 0.3P

P2 = 12000/ 0.3

P =

P = 200