Sample mid-term (2014) - solutions.docx

# Sample mid-term (2014) - solutions.docx

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ECON 0207 / 2222 Mid-Term Test Name: ____ suggested solutions ________________ Q. 1 Diagram (1) LRAS P SRAS SRAS’ SRAS” ´ P ´ E E ( P q + 1 ) = ¿ P SR E SR ^ P ^ E AD’ AD Y SR ´ Y (= ^ Y ) Y Brief explanation for part (a) Any factors that unambiguously leads to a downward shift of the AD curve would work. For example, the riskiness of the business increases in the future. As a result, the demand for loanable funds drops, drive down the equilibrium interest rate in the loanable funds market. Consequently, the price has to drop such that the money supply will increase until the loanable funds market and the market for money achieve equilibrium at the same interest rate. The new AD curve is AD’ in the above diagram. And the new short-run equilibrium is E SR with P SR and Y SR . Brief explanation for part (b) 1

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Using the adaptive expectation E ( P q + 1 ) = P q , when the economy is operating at E SR and when the labor contract is going to be renewed, labor will expect the price in the next period to be P SR . Hence, the new SRAS curve, SRAS’ will intersect LRAS at P SR .
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