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Assume that the expected change in price level is 4% and the actual change in price...

Assume that the expected change in price level is 4% and the actual change in price level is 6%. Please show and discuss the changes that will occur due to this contract. as well as the adjustments which will occur as the economy adjusts. Explain each of the changes illustrated on your graph.

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Answer #1

If the price level is higher than the expected ( let's say that the actual level is 6% and the expected level is 4%) then this leads to increase in the expected price level also. Workers demand higher nominal wage to compensate them for the higher cost of living.

Firms in turn will raise their prices to cover the increase they have done in the wages. This cause AS curve to shift upward to ASA. The new equilibrium is now at level X with higher price level Pn

This rise in the price level causes the real money supply to contract again and so the LM curve shifts back upward. The interest rate rises back to the initial level I0 and the level of output falls back to its initial level Y0

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