# Aggregate Demand and Shocks

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I need some help in answering these questions on aggregate demand and shocks:

Question 1

Suppose the economy has the aggregate demand curve

Y=3,401 + 2.888 M/P

And the price adjustment schedule

Pie = 1.2(Y _1 - 6,000/6000)

The money supply is 900 billion

a) Plot the aggregate demand curve and the potential GDP line, explained why the aggregate demand curve is not a straight line

b) If P0 = 0.5 what is Y0? Does this place upward or downward pressure on prices?

c) Compute the path of the economy - that is, calculate GDP, the price level, and inflation - for each year until GDP is within 1 % of potential

d) Diagram the economy's path on the demand curve plotted in part a, Then, draw your own version of figure assume the inflation was 0. From these graphs, does the economy overshoot or converge directly to equilibrium?

e)Assume now that inflation is given by pi = pi 1+ 1.2 { Y -1 - 6000/6000} Compute the path of the economy for the first five years and diagram the economy path as in part d s there overshooting.

What does pi -1 term in the price adjustment equation in part represent? Explain the relationship between this term and overshooting

Question 2

Suppose the economy is initially described by the following equations

Y= C+ I +G

C= 220 +0.63Y

I= 1,000 - 2,000R

X = 525 - 0.1Y- 500R

M= 0.1583Y - 1,000R

Pie = 1.2 [(Y -1 - 6,000/6000}]

Money supply = 900 billion, G =1,200Billion and output is at its potential level of $6,000 billion with a price level of 1. Then there is a money demand shock. The new money demand equation is given by

M= 0.1583Y - 2,00R

a) In the year of the shock, compute the value of GDP, the price level interest rates and the real money supply.

b) Using aggregate demand curves, illustrate the economy's path in the year of the shock and in subsequent years

c) Calculate the new long run equilibrium values for income, prices interest rates and the real money supply.

d)Could the Fed have done something to avert the adjustment process? If no, why not? If yes describe exactly what it could have done.

#### Solution Summary

This solution answers the three aforementioned questions with in-depth explanations, calculations and graphs.