Question

6. Assume that the AD curve of the economy is given by Y 15-100π + 1, where m is a demand shock (animal spirits, government spending, or money supply). The AS curve is given by 50(r where u is a supply shock (oil price, productivity). The variable π is the inflation rate, ETIS expected inflation rate, Y is output, and Y is long-run output. For numerical values, Y - Answer each equation using both graphs and math. Plot the above AD-AS curves on the (Y, π) diagram. Describe the slopes of both the AD a. curve and the AS curve. b. If the economy is currently at its long-run trend, what should be the equilibrium output? What is the equilibrium inflation rate in this economy? What should be the equilibrium expected inflation rate in this economy? Assume that expected inflation rate is constant at 5 percent. What happens when the C. oil price increases by 5 percent (v 0.05)? what is the equilibrium level of output? What is the equilibrium level of inflation? d. Assume that expected inflation rate is constant at 5 percent. What happens for 2 periods when money supply increases by 1 (m1)? (today and 1 period ahead) What is the equilibrium level of output today and 1 period ahead? What is the equilibrium level of inflation today and 1 period ahead? Now, assume that expectations are adaptive. That is, Επ-T-1, where π-1 is inflation e. in the previous period. Starting from the long-run trend, what happens for 2 periods when money supply permanently increases by 1 (m1)? (today and 1 period ahead) What is the equilibrium level of output today and 1 period ahead? What is the equilibrium level of inflation today and 1 period ahead? f. Assume instead that expectations are rational. That is, the agents solve the above AD- AS model and expect inflation to be E0.05 5 What happens to expected 100 2 inflation when money supply increases by 1 (m1)? Given this expected inflation, what is the equilibrium level of output today and 1 period ahead? What is the equilibrium level of inflation today and 1 period ahead? g. Based on your answers to d., e., and f., describe the effectiveness of monetary policy under different assumptions on inflation expectations

Answer 1

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