Question

2.1. Derive the AD and AS curve.

2.2. Show the AD/AS model graphically.

2.3. Why does modern monetary policy take rational expectations into account?

Answer 1

Derivation of AD cureve. the is and im coreve ther determine the AD schedule. The AD curve maps out the eqnilibrium. AD curve is drawn on the basis of following assumptions : ) A coustant Nominal money supply cm Money supply (m) is constant. & only price level varies. AD curve shows the amount of equilibrium output demanded at each price level. Derivation - Is equation : 4 = da (Ã -bi) ..-ig im eanation : i = 1 (K4-M/6). Lig substituting lie) in is. y = do XG [Ã - 2 CkY - M/P)] uz dG, Ā - det kl + LG b h Y+dGb k4 = dght & B na = 4(lt AG hk) = AGÃ t ho be the one Let dy =8 (fiscal policy multipuer).

beraphically) AD cureve - cm2 (m/P2) CM, (MP) AD 2 4

The derivation of AS curve involves 4 steps: 1. Translate output to employment. – OKUN's Law 2. Link prices charged by firms to their costs

3. Use Phillips curve relationship between wages and employment 4. Put the three components together to derive an upward sloping AS curve Ist Step: In short run, unemployment and output are closely linked. Okun's Law states — one extra point of unemployment costs 2% of GDP Output (Y) is assumed to be proportional to the employment (N) which gives the production function (Y =f (N)]. Production function : Y-aN Y/N = a ..(0) a input co-efficient or labour productivity or output produced per unit of labour Y → Output produced Y/N + Amount of output produced per unit of labour employed N + amount of labour employed IInd Step: The main component of total cost is the labour cost. Firm will fix the price of output which covers its cost. Firm may want to change more than cost but the competition from existing firms and the

per unit labour cost of production - :Per unit cost of production = per unit labour cost of production + some margin :: P = "+" (Where Z = other cost + profit margin) :Firm fixes price as a mark-up', (Z), on labour cost · P = (1 + 2) (2) If a = 3, that is, each unit of L produces 3 units of output. If each labour input is paid 5 WIS ss Then labour cost per unit of output === a 3 IlIrd Step: Phillips curve relationship between employment and wages Wory - w,[1+e(***) ... from iv explained carlier) 3)... (from iv explained earlier) Derivation of AS curve : Yla= N from ... (1) p-142(W) from.c.2) [Where: 2.. - 42(w.)? = 2*2-(w)] P1+1 → Price this year P. → Price of the previous year Putting the value of w,-, from (3) in equation (2) Since P, - [142] P., - 2,51+2(N="").rs)

As Yla = N or N = Yla; N = Y'la Putting the value in equation (5) from ... (1) P... - 2.[-(4410) Pro, = P.[1+ (Y-r')) By defining =€/Y* we get the AS curve fig. (13.1) PA+, = P, 11 + 1 (Y-Y*)) ...(7) :: AS curve shows the relationship between output level and prices (a) At Y → P,-, = P, At point B Y = Y → Full employment level of output :: Prices today P, . , = Prices last year (b) If Y > Y' → overemployment → At point C (Y>Y) Then Prices today > Prices last year (c) If Y <Y* → underemployment → At point A (Y_<Y') Prices today < Prices last year Join points A, B and C wa get the AS curve,

Price level Output FIG. 13.1. THE AGGREGATE SUPPLY CURVE