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Consider an economy with SRAS curve: Y = Ybar + a(P - EP)
Where Ybar is the natural rate of output and EP is the expected price level.
a) Depict a long run equilibrium of the closed economy AD-AS on a graph with Y on the horizontal axis and P on the vertical axis. Show the short run effects of a negative aggregate demand shock. Give one example of such a shock. Label your graph well. You don't need to solve for numbers in parts a) and b) of this question.
b) Carefully show how the economy will return to a new long run equilibrium in the absence of fiscal or monetary policy after the shock in part a).
c) Okun's Law states that:
u - ubar = -b(Y - Ybar)
Where ubar is the natural rate of unemployment. Derive the Phillips Curve. Is there a permanent trade-off between inflation and unemployment that policy makers can exploit? Discuss the role of expectations.
d) Consider two aggregate supply curves. The first has a slope of a = 2 and the second has a slope of a'=1. Which supply curve do you think is associated with "stickier" prices?
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