Question

1A. Graphically illustrate and carefully explain the impact of a general expectation of rapid inflation on the economy’s equilibrium price and real output in the short-run, assuming that the price level is flexible both upward and downward.

1B. Graphically illustrate and explain the impact of a decrease in aggregate demand on the economy’s equilibrium price and real output, assuming that the economy is currently operating at its full-employment output level and the price level is flexible upward but not downward. How would theanalysis be different if the price level is flexible downward?

Answer 1

a. As given, with the expectation of upcoming inflation, demand for product will rise as people will prefer hoarding of goods before the inflation hits the market.

In the short run output remains constant, as changing output can not occur quickly and thus need long term to alter.Graphically,

With output Q constant, Price increases from P1 to P2, and actually resulting in inflation in the short run.

B. Graphically,

Part A of diagram shows when price are flexible upwards and not downwards, thus even with lower output Y' production price will stay at P .

Part B od diagram shows when price are flexible downwards and not upwards, thus with a reduction in aggregate demand, output falls to Y' and prices too falls to P'.