C. Assume that the long-run aggregate supply is given Y = (2K^1/2)*(L^1/2) , whi

Question

C. Assume that the long-run aggregate supply is given Y = (2K^1/2)*(L^1/2) , while the short-run aggregate supply curve is horizontal at P = $1.0. The aggregate demand curve is Y = 5*(M/P), and money supply is M = $1,000. Assuming that the economys L = K = 2,500,

answer the following questions:

1. What is the income velocity, V?

2. If the economy is initially in long-run equilibrium, what are the values of P and Y?

3. Suppose the aggregate demand curve becomes Y = 3*(M/P).

a. What is the income velocity, V?

b. What are the short-run values of P and Y?

c. With the new aggregate demand function, once the economy adjusts to its long-run equilibrium, what are the values of P and Y?

d. Draw a diagram showing how economy moves from its initial long-run equilibrium (found in part 2), to the short-run equilibrium (found in part 3.b.), and then back to the long-run equilibrium (found in part 3.c)

4. Now, instead of changing the aggregate demand, assume that the Fed decreases money supply from M = $1,000 to M = $400.

a. What are the short-run values of P and Y?

b. With the new aggregate demand function, once the economy adjusts to its long-run equilibrium, what are the values of P and Y?

c. Draw a diagram showing how economy moves from its initial long-run equilibrium (found in part 2), to the short-run equilibrium (found in part 4.a.), and then back to the long-run equilibrium (found in part 4.b).

Explanation / Answer

1.

Y=5M/p

YP=5M, from fisher income equation (PY=MV), velocity is 5.

2. L=K=2500

Potential GDP = Y= 2(50*50) =5000

P=5000/5000 = 1

3.

a. Y=3M/p

YP=3M, so velocity is 3.

b. M=1000, short run P=1, Y =3000

c. Long run Y = 5000, P = 3000/5000 = .6

d.

Point A, when demand for money changes there is higher supply of money compare to demand. Since short run price is fixed, higher money supply will

4.

a. M=400, P=1, V=5, Y=2000,

b. Y

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