Question

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1. Graphically illustrate and carefully explain the impact of a general expectation of rapid inflation on the economy’s equilibrium price and real output in the short-run, assuming that the price level is flexible both upward and downward.

Answer 1

If the general expectation of inflation rises i.e. is rapid and aggregate supply is combination of price and output at a given expected price so expectation of rapid inflation leads to rise in expected price due to which AS curve shifts rightwards from AS to AS'.

Before the rise in expected price, the equilibrium price is P and equilibrium output is Q.

After the movement of AS curve towards right to AS' due to rise in expected price , economy's equilibrium price falls from P to P' and equilibrium output also rises from Q to Q'.