Suppose output is below potential output in year 0. Prices that year are given b

Question

Suppose output is below potential output in year 0. Prices that year are given by P0. In year 1 (with the level of potential output unchanged) the Fed stimulates the economy by shifting the aggregate demand curve until it interest the point (P0, Y*)

A= Sketch the aggregate demand curve for years 0 and 1. Describe the action taken by the Fed

B=Assume that the price adjustment process is given by equation Pi = Pi _1 (- 1) + f ( y_1 - y*/y*) If inflation in year 0 was zero, how do prices behave in year 1? Sketch the price adjustment curve for year 1

C=Explain why output in year 1 is above potential

D=In which direction should Fed have shifted the aggregate demand curve to set Y1 =Y*? Is it possible to say?

E=Given the Fed

Explanation / Answer

(a) Draw the AD curve for years 0 and 1. Describe what the Fed would do to make this happen?

The Fed increased the money supply in year 1 and thus the aggregate demand curve shifts to the right.

(b) Assume inflation expectations are adaptive. If inflation in year 0 was zero, how do prices behave in year 1?

Prices in year 1 fall, since output in year 0 was below potential.

(c) Why is output in year 1 above potential?

Because the AD curve has shifted and prices fell.

(d) In which direction should the Fed have shifted the aggregate demand curve to set Y1 equal to Y*?

It is not possible to say. It depends on how much prices fall in year 1 due to output being below potential.

(e) Given the Fed

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