Consider the following model of the economy
Consider the following model of the economy
Subject: Economics / Accounting
Question
Question 2 0” prices and the AS—AD mode! in the medium run
Consider the following model of the economy:
0 Wages are determined by the wage-setting equation: W = P9 (5 – 40a)
where P9 is the expected price and the unemployment rate at =(L-Nj/L
Prices are determined by the following equation: P=(1+m)W where m=0.6
Linear production function: Y=f(N)=N
Labour force is fixed, L=100
Consumption function: C=10+0.5(Y—T)
Investment function: i=12+0.3Y—1000i
Government spending: 6:100, Taxes: T=90
The central bank is using the following Interest Rate Rule: it: in + a(P—PT) where 0:2, and its
price level target PT=10.
Derive and draw the AS relationship for this economy. Explain in words.
b. Find the natural rate of unemployment, U”, the natural level of employment, N", and the natural
level of output, Yn.
Derive and draw the AD relationship for this economy. Explain in words
d. What are the medium-run values of P and i— ie PH and in? m S“ e. What will happen to the economy in the medium run if the markup , m, increases to 0.7? Explain
why you can interpret the rise in m as equivalent to an oil price increase. Find the new values of
Yn and in. Show on the diagram.
