Question

1. Suppose the economy has the aggregate demand curve ? = 3000 + 4( ? ? ) and the price adjustment schedule. ? = 0.6?−1 + 0.5( ?−1−6000 6000 ). The money supply, M, is 800. The price level is denoted P, real output Y, and inflation . Assume the economy has zero inflation initially ( π0 = 0). The initial price ( P0 ) is 1 and initial output ( Y0 ) is 6200.

a. What does potential GDP equal?

b. Compute the price level and output for period 1.

c. Compute the price level and output for period 2.

Answer 1

A) The potential GDP is 6000.

The price adjustment schedule has two components first the previous year inflation ( basically it Should be expected inflation but mostly we assume expected inflation equal to previous year inflation)

And second deviation from full employment output or potential output where inflation remain constant and equal to the previous year inflation.

So full employment output is given 6000 in the equation ,so potential gdp is 6000.

B)price adjustment schedule,=0.6*0+0.5(6200-6000)/6000=0.5*200/6000=0.0167

New price level(p1)=1+0.0167=1.0167

Output (Y1)=3000+4*800/1.0167=3000+3147.44=6147.44

C) price adjustment schedule period2=0.6*0.0167+0.5(6147.44-6000)/6000=0.01002+0.0123=0.02232

New price level(p2)=1.0167+0.02232=1.03902

Output (y2)=3000+3200/1.03902=3000+3079.825=6079.825