5. The long-run aggregate supply curve Aa Aa Suppose the hypothetical economy of

Question

5. The long-run aggregate supply curve Aa Aa Suppose the hypothetical economy of Larryopia produces real GDP of $40 billion when unemployment is at its natural rate. Use the purple line (diamond symbols) to plot the economy's long-run aggregate supply (LRAS) curve in the following graph. Then place a black point (X symbol) on the point representing the equilibrium price and output level. PRICE LEVEL 132 128 124 120 116 112 108 104 100 LRAS Equilibrium 0 10 20 30 40 50 60 70 80 INCOME, OUTPUT (Billions of dollars)Help Clear All

Explanation / Answer

The economy's long-run aggreagte supply (LRAS) curve will be a vertical line at output =40. The equilibrium would be at Y=40 and price = 116.

The long-run equilibrium level of output is determined by ( capial, labour and technology ). Therefore, it will ( remain at the full-employment level ) if the aggregate demand curve shifts to the right.

Th LRAS does not depend on price. When there is an increase in aggregate demand, the AD curve shifts upward. The new equilibrium has the same Y but higher P.

In the long rum, continuously increasing the growth rate of money supply wil change the price level and the inflation. This comes from the Quantity Theory of Money which says that

PY= MV.

P= Price level, Y = output , M=money supply, V=velocity of money.

V is assumed to be constant in the long run. Y is also fixed at the full-employment level. Then an increase in money supply (M) causes a proportional change in price (P). Because price is changing, inflation happens in the economy.

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