Ch. 7 - ECN101 Intermediate Macroeconomics Professor...

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ECN101 Intermediate Macroeconomics Winter 2009 Professor E.A.Frenkel Homework 7-Solutions (5) Your economy is at full employment Long Term/Short Term equilibrium. Wheat is important to your economy (everyone eats bread) and you must import all of your wheat. Now the price of wheat skyrockets, and this means a major rise in your costs of production across your economy. If your government does nothing in the face of this "adverse supply shock" what happens in the short run using the simple AD-AS diagram? What happens in the long run? If your government wants to avoid waiting for the long run result, what must it do? What happens in the short run if the government takes action to avoid the long run result (on the AD-AS diagram)? Solution: A major rise in the costs of production across your economy is an adverse supply shock. Therefore, in Figure 1 the short-run aggregate supply curve shifts upward from SRAS 1 to SRAS 2 . Given aggregate demand is held constant, the economy moves from point A to point B: the price level rises from P 1 to P 2 and the amount of output falls below its natural level. If your government does nothing, in the short run, the economy will experience stagnation(falling output, rising prices). In the long run, prices will fall back to P 1 to restore full employment, that is, the economy will eventually move back to point A. P 2 P 1 B A P Y AD SRAS 2 LRAS Y SRAS 1 Figure 1 Y
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If your government wants to avoid waiting for the long run result, the government must expand aggregate demand to bring the economy toward the natural level of output more quickly. If the increase in aggregate demand coincides with the shock to aggregate supply, the economy goes immediately from point A to point C, as shown in Figure 2. The cost of this policy is that price will stay at the higher level P 2 permanently. (6) Next, using the AS – AD theory as developed in Chapter 9, what would happen to income and the price level if a "positive" supply shock was accompanied simultaneously by a rise in the money supply and rise in the velocity of circulation. Begin from a position of full-employment equilibrium. Will the price level be higher or lower than where it began? What about income. If income and the price level are to end up exactly where they began, what assumptions do you have to make about the size of the supply shock, money supply change and velocity rise? Solution: A positive supply shock causes the short run aggregate supply curve shifts downward from SRAS 1 to SRAS 2 . At the same time, a rise in the money supply and rise in the velocity of circulation causes the short run aggregate demand curve shifts outward, from AD 1 to AD 2 , since MV=PY, as M and V increases, for any given P, Y has to increase as well. In the short run, the combined result is the economy moves from point A to point B: the price level falls from P 1 to P 2 and the amount of output rises above its natural level. In the long run, in response to the high demand, wages and prices rise. It eventually rises to
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Ch. 7 - ECN101 Intermediate Macroeconomics Professor...

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