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# The quantity equation implies δ m δ v δ p δ y or

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The quantity equation implies M + %Δ V = %Δ P + %Δ Y or M + %Δ V = PY . Since velocity is constant ( V = 0 ), the change in nominal GDP ( PY ) equals the money growth rate and the change in real GDP is Y = %Δ M - P = 8% - 5% = 3% (5) [8 points] Unemployment Let’s assume that supply of labor is fixed in the long run, and thus the labor supply curve is vertical. Suppose that a country experiences a reduction in productivity that lowers the marginal productivity of labor for any given level of labor (a) [4 points] Suppose the labor market were always in equilibrium. Illustrate graphically the effects of the reduction in productivity on real wage and unemployment The reduction in productivity causes a lower real wage and no change in unemployment (b) [4 points] Will your answer in part (b) change if the real wage were rigid? Briefly discuss The reduction in productivity causes no change in the real wage and a rise in in unem- ployment (6) [14 points] Short-run Economic Fluctuations Assume that the long-run aggregate supply curve is vertical at Y = 3 , 000 while the short-run aggregate supply curve is horizontal at P = 1 . 0. The aggregate demand curve is Y = 3( M/P ) and M = 1 , 000. (a) [2 points] If the economy is initially in long-run equilibrium, what are the values of P and Y ? P=1.0; Y=3,000 5

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(b) [2 points] Now suppose a supply shock moves the short-run aggregate supply curve to P = 1 . 5. What are the new short-run equilibrium values of P and Y ? P=1.5; Y=2,000 (c) [3 points] If the aggregate demand curve and long-run aggregate supply curve are un- changed, what are the long-run equilibrium values of P and Y after the supply shock? P=1.0; Y=3,000 (d) [4 points] You are an economist working for the Federal Reserve. Use the aggregate demand-aggregate supply model to illustrate graphically your policy recommendation to accommodate this supply shock, assuming that your top priority is maintaining full employment in the economy. Should money supply ( M ) be increased or decreased? Why? The Federal Reserve must increase the money supply in the short run, in order to return the economy to the natural rate, moving the output to its original level with a permanently higher price level (e) [3 points] Suppose that after the supply shock the Fed wanted to hold output at its long-run level. What level of M would be required? M=1,500 6
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