Question

a. If the money supply is $800 and velocity is constant at 2.5, what is the aggregate demand curve (function)?

b. If the long-run aggregate supply is y=400 what will the (long-run) equilibrium price level be?

c. If the money supply decreases to $600 what will happen to output and the price level in the long run? Show this on a graph.

Answer 1

a) Use the rule P x Y = M x V under quantity theory of money

P x Y = 800 x 2.5 = 2000

Hence AD function is Y = 2000/P

B) LRAS is Y = 400. Hence the long run price level is AD = AS or 400 = 2000/P. This gives P = 2000/400 = 5

C) Now M is 600 so we have

P x Y = 600 x 2.5 = 1500

Hence AD function is Y =1500/P

Price level 1500/400 = 3.75 and Y = 400. This shows that in the long run when aggregate supply is fixed, output stays at 400 and all the decrease in money supply is reflected in a decline in price level