Question

1. Suppose you have the following AD and AS curves:

Y = 800 − 40π (AD equation)

Y = −50 + 60π (Short Run AS equation)

Y = 400 billion (Long Run output)

(a) Calculate the real GDP and inflation in equilibrium in the short run. Calculate the current output gap.

(b) Is the economy in the short run facing a recession or an expansion? Explain.

(c) Was the recession or expansion caused by demand or a supply shock? Explain.

(d) If the AD and Long Run output do not change, what should happen to the short-run AS curve in the long run? What would happen to the expected inflation rate in the long run?

(e) Calculate the expected inflation in the long run, and obtain the new adjusted short-run aggregate supply curve

Answer 1

a) at eqm

AD = SRAS

800-40π= -50+60π

850= 100π

π= 8.5%

Y = 800-40*8.5

= 800-340

Y*= 460

Output gap = Y*-Y

= 460-400

= 60

.

B) as current Y* is higher than potential level

So economy facing expansion

.

C) expansion could be caused by both demand or supply shock

.

D) SRAS should shift to left upwards to bring Economy at long run eqm

So Expected inflation will be higher

.

E) in long run,

Y = long run level = 400

So, from AD

400=800-40π

40π= 400

π= 10%

New SRAS : y = -200+60π

So that at y = 400, π= 10