Suppose an economy\'s aggregate demand function is given by (in billions): Y = 1

Question

Suppose an economy's aggregate demand function is given by (in billions): Y = 19,000 - 25,000pi Where Y is output and it is inflation. The initial inflation rate is 0.05 (5%). Potential output is 18.000. What is the output level in the short-run? What does the output gap equal? Is the output gap expansionary or recessionary? According to the AS-AD model, how will the economy gel back to its potential level of output in the long-run? What is the inflation rate in the long-run equilibrium (when output is at its potential level)?

Explanation / Answer

1. Output level in hte short run is = 19000- 0.05 *25000 = 17750.Output gap is equal yo 250(18000-17750).Output gap is recessionary.

2.In the long run SRAS curve will keep shifting rightward untill and unless expected price equals actual price.Initially expected price is greater than the actual price,workers will revise their expectations and lower down the price.When there is decrease in the expectations of worker regarding price AS shifts rightward leading to decrease in real wage and inflation finally and hence long run equilibirium is achieved.

3.Inflation rate will decrease and will be 0.04 .

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