Question

Question 4) Consider an economy with two kinds of firms : • Firms with sticky prices have ps • Firms with flexible prices pf A) Derive the following SRAS that we discussed in the class. You have to explain your steps and assumption clearly ( 10 points) Y=Y +a (P-EP), Where a = s/[(1-s)a), and s=0.5 is the fraction of firms with sticky prices; a=0.5 is just a parameter. Y=200 B) How do you interpret the SRAS? (5 points) C) Assume that the AD curve is given as Y= 1000 - 10P, and we are in the long-run equilibrium. Determine the values of Y, P and EP in the equilibrium. (15 points) D) Suppose that the share of firms with sticky prices increase to s=0.75. What will be the impact of that on your answer in part b? Calculate it? (10 points)

Answer 1

Given,

a) Derived the SRAS.

To Given, y = 7 + a(P-EP) Glhere, firms set their desired prices as : Pq = ptacy-fo Ps - EPtaley-87) Thus, The price firms, they expect out put to be full employment. .: EY=ET .: Ps = Ep Then the aggregate price level is P = SP 3+ (1-5)Ps P = SEP+(1-5) [Pt a Cy- ] 08,[1-1+5] p= SEP(1-5) a (7-7) og sp = SEP+ U-s)a (4-5) or P = Ep + (1-5) a (77) S or P- EP = (1-5) a [4-7] -(P-EP) = 4- Ī (d-s) a .NETt-sja [f-EPI... SRAS This are the equation of SRAS B) How do you interpret the SRAS ? Solution : calhere, g: 0 = 05 ; 7 = 20 D :

.: Y = 200+0.5_ (P-EP). 0.500.5 .:7 = 200 + 2(P-EP) This is the show that the derivation of output from the natural rate is twice as much the derivation of paice level from its expected rate c) Determine the values of y, P and EP in the equilibrium Solution : Calhere, AD : Y = 1000-dop SRAS; Y = 200 + 2 CP-EP) LRAS: Y = ✓ = 200 .: At long run equilibaium : y = 200 i pa to00-200 e to - 800 10 TP = 80 Thus, P = EP=80 D) Given, sticky prices increase 5:0.75 To find, Calhat will be the impact of that on your answer in part of b. calculate it b? Solution, 1 s= 0.15 .id=6 (-s) a

= 0.75 0.25% 0.5 = 0.75 - 0.125 2 ? G1 . Here, SRAS=y=200+G(P-EP) Also, LRAS: Y=200 and P= Ep with AD : Ya looo-lop iP=&P=80 and y=200 50, the answerin (C) does not change with Change in s.