Question

1. (50 points) Draw a graph of the overall economy using the Neoclassical economic model, including the LRAS, SRAS, and AD curve. Draw the model so that this economy is operating at its full potential. 1. Based on this information, is the economy operating with an unemployment rate that is above or below the natural unemployment rate? 2. If AD were to suddenly increase, what would happen to the price level and Real GDP in this economy immediately after the increase? Show on your graph. 3. If AD were to suddenly increase, what would eventually need to happen to the SRAS curve for the economy to, once again, operate at its full potential? Show on your graph. 2. (50 points) For the following questions, evaluate whether the statement is "true" or "false". Then, provide a brief explanation to justify your answer. 1. In the Keynesian model (such as the one shown in Figure 12.3), an increase in AD will always lead to more Real GDP. 2. The general lesson from the Phillips curve is that an increase in inflation rates will lead to lower unemployment rates in the short- run. 3. If the economy is struggling, Keynes recommends that the government raise taxes in order to stimulate the economy, 4. The economy will adjust more quickly if people generally exhibit adaptive expectations (rather than rational expectations). 5. Suppose that researchers find that prices in the U.S. are very slow to adjust ("sticky prices"). This finding will tend to favor an economy that is in line with Keynesian economic thinking.

Answer 1

(Question 1)

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (potential GDP) Y0.

(1)

When economy operates at full-employment level, actual unemployment rate is equal to natural unemployment rate.

(2)

When aggregate demand increases, AD curve shifts to right, which increases price level and increases real GDP as an immediate effect.

In above graph, when aggregate demand rises, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real output Y1, causing an inflationary gap of (Y1 - Y0).

(3)

Eventually, higher price level will increase input prices. Firms will reduce production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring real GDP to potential GDP level and the inflationary gap is wiped out.

In above graph,eventually SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.

NOTE: As HOMEWORKLIB Answering Policy, 1st question has been answered.