Question

Consider the AD-AS model, with the AD curve derived from the quantity theory of money. Suppose the economy is initially in long-run equilibrium, when there is a sudden rise in demand for real balances for any given level of output, and simultaneously also an improvement in productive technology that permanently increases how much firms can produce with any given amount of the factors of production.

(a) Immediately following these shocks, what happens to velocity? To the AD curve? The LRAS curve? The SRAS curve?

(b) Show the initial AD, LRAS and SRAS curves in a graph, and then show how each curve shifts (if at all) in the short run in response to the above shocks.

(c) Explain what happens to the amount of labour firms employ L, output Y , and the price level P upon arrival of these shocks (i.e., in the short run). In the graph you drew in part (b), show the short-run equilibrium combination of Y and P.

(d) In the long run, assuming no further changes in AD, what must happen to L, Y , and P? Show the new long-run equilibrium in the graph you drew in part (b).

Answer 1

Answer:

(a) The real money demand is the function of k and real output that is (M/P)^d = k * Y. Now k is inversely related to the velocity of money. With the sudden rise in demand for money, with given Y the k will also increase. With an increase in k, the velocity will decrease.

With the decrease in velocity, the nominal GDP (P*Y) will reduce. Hence this will shift the AD curve inwards.

The long run aggregate supply curve (LRAS) will move outward and short run aggregate supply (SRAS) curve will remain constant.

(b)

The initial equilibrium point of output and price is denoted by Y₀ and P₀ respectively. There is no change in SRAS hence the curve does not change.

(c) With increase in production technology, the number of labour hired by firms will increase. This will further increase the output.