1.
DAD – SAS Model.
Assume that the economy is initially at Yn with a steady
inflation rate. For each of the following scenarios, use a DAD-SAS model to
clearly show
and provide a brief economic explanation
of what is happening to the
output ratio and inflation during the first 3 years of the adjustment process (i.e.,
years 1, 2, and 3). Also, clearly show
where the economy will be after long-term
equilibrium is re-established.
(20 points.)
a.
After the invention of a new high-speed computer chip, business firms
decide to significantly upgrade their computer networks.
In year 1, an increase in autonomous I shifts the DAD curve to DAD1 and increases
Y-hat to Y-hat1. Inflation stays at p-dot0 because Y-hat0 = 0.
In year 2, the SAS curve shifts up to SAS2, increasing inflation to p-dot2 because Y-
hat1 > 0. Higher inflation reduces the real Ms, shifting the LM curve left, raising r,
crowding out some interest-sensitive spending, particularly I, which reduces Y-hat to
Y-hat2. Nevertheless, Y-hat2 > 0.
In year 3, the SAS curve shifts up to SAS 3, increasing inflation to p-dot3 because Y-
hat2 > 0. The rise in inflation will be less than in year 2 because Y-hat2 < Y-hat1.
Higher inflation reduces the real Ms, shifting the LM curve left, raising r, crowding
out interest-sensitive spending, particularly I, which reduces Y-hat to Y-hat3.
Although Y-hat3 < Y-hat 2, Y-hat3 > 0.
This process continues in smaller and smaller steps until the SAS curve has shifted up
to SASn, inflation has increased to p-dotn and Y-hat has fallen back to Y-hatn. Long-
run equilibrium is re-established at Y-hatn = Y-hat0 and p-dotn > p-dot0.
Y0