Question 1

Assume the economy begins in both short run and long-run equilibrium (point A)
Increase in the size of the budget deficit
( )

The initial move is in the direction of point C - in SR firms are assumed to supply whatever is
demanded without change in price, i.e. the inflation rate doesnt change.
At point C, > :
firms attempt to raise the relative price of their product
prices are increased at a rate in excess of the rise in costs.
all firms behave in this manner, the rate of inflation rises rather than the relative price rising.
So the increase in the rate of inflation causes a movement up and to the left along the AD curve (i.e.
the actual output decreases) to point B (the SR equilibrium point) for the two reasons:
(i) the movement along the Reserve Banks policy reaction function
(ii) a series of more automatic responses of aggregate expenditure to inflation.

However, the size of the decrease in aggregate demand may be different depending on

The size of the budget deficit

The size of the decrease in the cash rate
The responsiveness of private sector expenditure, C and I to interest rate
change

Above is the short run response. (A to C to B)

However, at point B, still expansionary output gap
Firms will still attempt to raise the relative price of their products to reduce the quantity
demanded of their product
Prices are increased at a rate in excess of the rise in costs.
All firms behave in this manner, the rate of inflation rises rather than the relative price rising.
with a time lag, the expected rate of inflation also rises.
aggregate supply curve will shift up from AS1 to AS2 and the higher rate of inflation will cause a
movement up and to the left along the aggregate demand curve AS2.

A new long run equilibrium will be reached at point D with output equal to potential output,
unemployment equal to the natural rate and a higher actual and expected rate of inflation.

AS2
Inflation

AS1
D

2 = e2
B

0 = e0

AD2

AD1

Y*

Y1

Output Y

Question 2

higher expected rate of inflation

higher actual inflation
aggregate supply curve shift to the left, i.e. AS2 and as the actual rate of inflation rises there will
be a movement up and to the left along the aggregate demand curve AD.
So there will be new short run equilibrium where AS 2 intersects the AD curve point B. So at B, not
only is inflation at a higher rate, but output is lower and is below the potential level. So with output
below potential output, the actual rate of unemployment is above the natural rate of
unemployment that is, there is now cyclical unemployment.

While point B represents a point of short run equilibrium, it is not a point of long run equilibrium
since output is below potential output.
So to begin, focus on the automatic impacts that a higher rate of inflation may have on reducing
aggregate demand.
(a) the wealth effect of a change in the rate of inflation on the real value of money
(b) a change in the distribution of income and wealth.
(c) uncertainty and the saving for a rainy day hypothesis
(d) the international competitiveness effect
However, as the rate of inflation rises, the RBA will move along its PRF raising the official (nominal)
interest rate which will raise real market rates causing a reduction in private sector expenditure (C
and I).
So the economy will move to the new short run equilibrium at point B with a higher rate of inflation
and a lower output level Y1, which is below potential output.
Diagram 1

Inflation

AS2
AS1

e0 = 0

AD2
Y1

Y*

AD1

Output Y

First case: RBA does not shift PRF:

at point B, an contrationary output gap
Firms will still attempt to reduce the relative price of their products to increase the quantity
demanded of their product
Prices are increased at a rate lower the rise in costs.

 All firms behave in this manner, the rate of inflation decrease rather than the relative price
decrease.
with a time lag, the expected rate of inflation also decrease.
aggregate supply curve will shift down from AS2 to AS1 and the lower rate of inflation will cause a
movement down and to the right along the aggregate demand curve AS2.
So there will be a long run equilibrium where AS 1 intersects the AD curve point A, which is the
initial long run equilibrium.
Diagram 2

Inflation

AS2
AS1

e0 = 0

AD2
Y1

Y*

AD1

Output Y

Second case: the Bank responds to the increased rate of inflation by shifting the PRF:
Increased concern about inflation,
upward shift of the PRF: at any inflation rate the Bank sets a higher official interest rate.
shift the AD curve to the left to AD2 so that the new short run equilibrium is at point C on AS2
rather than at B.
So at C, output will be lower than at B at Y2 rather than Y1. So at C, output is further below
potential output than at B and there is more cyclical unemployment this is the cost of the shift of
the policy reaction function and the lower rate of inflation (2) at C compared with (1) at B.

So at C, output is below potential output so a firm will wish to sell more of its product to use its
capacity at a normal rate of usage. To do this the argument is that each firm will lower the rate at
which it is increasing prices in order to lower the price of its product relative to other firms and with
a lower relative price move down and to the right along its individual demand curve. However, as
each firm responds in this way, the rate of inflation falls rather than the relative price changing.
Now with a lower rate of inflation there will follow a decrease in the expected rate of inflation and
as a result, the aggregate supply curve (AS) shifts down and simultaneously there is a movement
down and to the right along the AD curve. This movement needs to be explained only briefly, if the
movement up and to the left along the AD curve was explained in detail at an earlier point in the
answer.
So the economy returns to point D. In returning o the long run equilibrium at D, we are assuming
that the RBA does not shift (back) its PRF.

Inflation

AS2
AS1
AS3

e0 = 0

C
A

e3 = 3

D
AD2

Y2 Y1

Y*

AD1
Output Y

QUESTION 3
In the short run, the equilibrium inflation rate and output level are given by the intersection of the
SRAS and AD curves. Algebraically, the short-run equilibrium level of output is found by substituting
the current inflation rate into the AD equation. Thus, in the short run,

Y 13,000 20,000(.04)
12,200
and inflation = 4%, the current level of inflation.

b. In the long run, the equilibrium inflation rate and output level are given by the intersection of the
LRAS and AD curves. Algebraically, the long-run equilibrium inflation rate is found by substituting the
level of potential output into the AD equation. Thus, in the long run,

12,000 13,000 20,000

1,000 20,000
1,000
.05 5%
20,000

and the long-run level of output equals 12,000, the potential output level.