Assume that aggregate supply is determined by the sticky-price model in which th

Question

Assume that aggregate supply is determined by the sticky-price model in which the fraction s (0, 1) of the firms in the economy have sticky prices, and the fraction 1 - s of the firms have flexible prices. The sticky price firms set their prices p according to the following equation: p = P^e where P^e is the expected aggregate price level (overall prices). Notice that deviations of income from the natural level of income Y -Y don't factor into sticky-price firms' price setting because their expected level of income equals the natural rate Y^e = Y. Flexible price firms set their price p according to the following equation: p = P + a(Y - Y) a > 0 where P is the aggregate (overall) price level. Aggregate prices in the economy are simply a weighted average of the prices set by the sticky price firms p and the flexible price firms p: P = sp + (1 - s)p Derive the aggregate supply equation that results from this sticky-price model (i.e., aggregate output Y as a function of everything else). What happens to the aggregate supply equation as the fraction of sticky-price firms goes to 0 (s rightarrow 0)? Why? What happens to the aggregate supply equation as the fraction of sticky-price firms goes to 1 (s rightarrow 1)? Why? Consider a policy action designed to shift aggregate demand, either an increase in government spending or an increase in the money supply. How does the fraction of sticky price firms affect how much this policy is able to stimulate an increase in GDP?

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Assume that aggregate supply is determined by the sticky-price model in which th

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