Question

Help with graph, fill in the blanks and drop downs.

Drop Downs:

1. more/less

2. higher/lower

3. (short-run change in output):

no change/decrease/increase

4. (long-run change in price level):

same/lower/higher than/as initial expectations

5. (long-run change in output):

no change/decrease/increase

4. The rational expectations model 

Suppose the U.S. economy is in equilibrium at a potential output of $10 trillion so that unemployment is at the natural rate. At the beginning of the year, the Federal Reserve announces that its monetary policy will aim to maintain output at potential output and sustain the current price level throughout the year. Firms and workers negotiate annual wage and resource price agreements based on the belief that the Fed is committed to price stability. 

The following graph shows the aggregate demand curve (AD), the long-run aggregate supply curve (LRAS), and the short-run aggregate supply curve (SRAS) at an expected price level of 120. 

Now suppose that several months later, the Fed abandons its stated goal of price stability and shifts toward an expansionary monetary policy. On the following graph, show the short-run effect of this policy by shifting the appropriate curve or curves.

In the short run, the expansionary monetary policy will result in a price level of

On the previous graph show the long-run effect of the expansionary monetary policy by shifting the appropriate curve or curves.

Because the wages workers agreed upon at the beginning of the year now buy than had been expected in real terms, workers eventually renegotiate wages, assuming a price level of _______ .

Suppose next year, the Fed once again announces that its monetary policy is aimed at maintaining price stability at the level reached last year (the price level you found in the previous question) and output at potential output ($10 trillion). However, because the government reneged on its promise last year, workers and firms suspect that the Fed will again shift to an expansionary policy. As a result, in anticipation of the Fed's actions, wage rates and resource prices are negotiated in the expectation of _______ inflation in the current year. 

Which of the following most accurately describes the government response to new wage rates and resource price agreements and the long-term economic outcome? 

• The Fed once again shifts toward an expansionary policy, and the economy's output returns to potential output. 

• The Fed pursues a stable monetary policy, and the economy's output rises. 

• The Fed pursues a stable monetary policy, and the economy's output declines.

• The Fed once again shifts toward an expansionary policy, and the economy's output declines. 

Complete the following table to compare the results of an unanticipated expansionary policy to those of an anticipated expansionary policy in the short run and long run. Determine whether, in the short run, the level of output increases, decreases, or remains unchanged relative to the potential output level when the expansionary policy is anticipated versus unanticipated. Additionally, determine whether, in the long run, the actual price level is above, below, or the same as initial expectations under both scenarios, and, again, determine whether the level of output increases, decreases, or remains unchanged.

Answer 1

The expansion of money supply will lead to lower interest rates and an increase in aggregate demand. This means that the AD curve will shift to the right.

Because of the shifting of AD to the right, price will increase. This is shown below.

LRAS Price AD 10 11 Output

There will be an increase in prices, as shown. This means workers will be able to buy less than before at the same income level. The LRAS will shift to the left, increasing the prices further. Workers will now need to negotiate so that they can buy same as before. This is shown below

SRAS SRAS 140 ---- 130 --- Price 120 AD 10 11 Output

Because the wages workers agreed upon at the beginning of the year now buy less than had been expected in real terms, workers eventually renegotiate wages, assuming a price level of 140.

Since the workers expect the Fed to renege on its policy and expect and expansionary policy, that means they expect higher inflation next year.

TO curb the increased prices, the Fed would pursue a stable monetary policy, and the economy's output declines.

Summary-

Short run change in output	No change	Decrease
Long run change in Price level	Same as initial expectations	Higher than initial expectations
Long run change in output	No change	No change