Question

Assume that an economy is initially operating at the natural rate of output (Y ). A short-run

aggregate supply equation is given by Y t = Y + α ( P t − P te ) ,

where Y is output, P is the price level, P e is the expected price level, and α > 0

1. (a) What is the slope of the aggregate supply curve?
2. (b) According to the sticky-price model, the value of α depends on the fraction of firms with sticky prices. Other things being equal, if a greater proportion of firms follows the sticky-price rule, what happens to the slope of the AS curve?
3. (c) Use the model of aggregate demand and aggregate supply to illustrate graphically the short-run and long-run effects on price and output of an unexpected expansionary monetary policy change

Answer 1

Y t = Y + α ( P t − P te )

a) The slope of Aggregate supply curve is 1/a.

b) The slope of AS curve ( 1/a ) increases as the fraction of firms with flexible prices increases in the sticky-price model and follow a direct relationship. Therefore, if a greater proportion of firms follows the sticky-price rule, the AS curve will be flatter which means the slope decreases..

c) In the short run ,this positive AD shock moves output above its natural rate and P above the level people had expected. AD=C+I+G+NXA, D, equals, C, plus, I, plus, G, plus, N, X equation, anything that increases C, I, G, or NX will shift AD to the right. Due to the shift output has increased.

In the long run, Pe rises, LRAS shifts up, and output returns to its natural rate.