Question

Suppose that workers and firms perfectly forecast inflation, so that the real wage remains unchanged as the price level rises over time. Prices and wages rise at the same rate, which implies that the real wage stays constant. The following graph shows the aggregate demand curve (AD) in an economy in long-run equilibrium. Assume the natural rate of unemployment is 6%, and potential output is $50 trillion. Use the orange points (square symbol) to draw the aggregate supply curve in this case, and use the black point (plus symbol) to mark the equilibrium price level and real GDP.

Answer 1

AS curve is Vertical at potential GDP level

180 170 Aggregate Supply 160 150 140 Equilibrium PRICE LEVEL 130 120 110 100 90 AD 80 10 20 90 100 30 40 50 60 70 80 REAL GDP (Trillions of Dollars)

SRPC is Vertical at natural Unemployment rate, 6%

π= πe ( expected inflation)

10 9 Short run Phillips curve 8 6 INFLATION RATE (Percent) 3 N 1 0 + 2 3 4 5 6 7 UNEMPLOYMENT RATE (Percent) 8 10

.

As money supply Decrease, so

1) Decrease in inflation

2) no change in Unemployment

3) no change in real GDP

.

School of thought : rational expectations theory