Assignment 2 a PDF

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ASSIGNMENT 2...

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Question a): Inf lat io n

AS1

AS2 A Πe B

Π1 C

AD

Y* At first,

Output Y

the point A is the equilibrium point for both short run and long run

equilibrium, where actual inflation πA is equal expected inflation πe. And the actual output equals to potential output Y*. Since Australia experiences a positive inflation shock, the aggregate supply curve shifts down from AS1 to AS2. So, the actual rate of inflation decreases and initially is in lack of the expected rate until, with a time lag the expected rate decreases to the new lower actual rate. The economy moves down and to the right along the AD curve, from point A to point B. Because with an increase in aggregate demand due to the decrease rate of inflation, output is more than potential output and firms start to increase the rate at which they are increasing prices.

Therefore, the new short-run equilibrium is at B rather than C. At the point B, real GDP is greater, as the output increased. And negative cyclical unemployment exists as the actual output is more than potential output.

But point B is a point of short-run equilibrium only as it is associated with a positive output gap – an expansionary gap. With an expansionary gap, firms raise prices at a higher trying to increase the products’ relative price because firms selling more products than they would wish to. As all firms act in this way, the actual rate of inflation increases rather than an increase in firm’s relative price occurring. The increase in the actual rate of inflation causes the move up and to the left along the AD curve. And with actual inflation increasing, this will bring the expected rate of inflation to increase also and cause the AS2 curve shifts back to its original position. And the economy situation also come its original status. The unemployment rate is at the natural rate and the real GDP level comes back its original level.

Question b): AS1

Inflation π

AS2

A Π1=π1e B

Π2=π2e

AD

Y*1

Y*2

Output Y

At this part, the combined consequences are needed to take account, which is not only the effects of the shift of AS curve, but also the change of potential output. Therefore, it includes two situations. (1). The relative size of the shift of AS is greater than the size of the change of potential output. In this case, the economy consequences are as same as the consequences of the question (a).

(2). The relative size of the shift of AS is less than the size of the change of potential output. At this case, the economy consequences follow this way: Since Australia experiences a positive inflation shock, potential outputs increase from Y*1 to Y*2. With the increase in potential output, at the initial rate of inflation π1, there is a contractionary gap, because actual output Y*1 is now less than potential output Y*2. In the presence of a contractionary output gap, actual output is less than potential output and there is positive cyclical unemployment since the actual rate of

unemployment will be greater than the natural rate. With a contractionary gap, firms raise prices at a lower rate attempting to decrease the product’s relative price because output is less than potential output – firms are selling less than they would wish to. As all firms behave in this way, the actual rate of inflation decreases rather than a decrease in a firm’s relative price occurring. Actual inflation and in turn with a time lag, expected inflation will decrease. And the decrease actual rate of inflation brings a movement down and to the right along AD curve. Consequently, the aggregate supply curve will shift down from AS1 to AS2. Together, these changes generate a new long-run equilibrium at point B....