Eco1011 Essay

1248 Words Apr 7th, 2013 5 Pages
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School of Economics ECO1011S Macroeconomics I Tutorial Solution 11 (Week 12) HOMEWORK (26 marks)

1.

If inflation cannot occur without money, does this mean that changes in the money stock always causes changes in inflation and that controlling the money stock is the only way to control inflation? (6) This question needs to be simplified to: What is the connection between money supply and inflation? This is the situation of monetary validation. Assume the economy starts off at some stable position (E0) along the LRAS (at Y*), but there is a shock to the system such that Aggregate demand increases (rightward shift). The economy is now in an unstable position since an inflationary
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1

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(1) Exogenous Shock Increase in AD
P3

LRAS

SRAS1
2

(2) SRAS to shift leftwards

SRAS0

E2 E1
3

(3)Higher price level

P2 P1 Po Eo

1

AD2 AD0 Yo
*

AD1

Y1

Inflationary gap Qd of Money increases If r is fixed then Money supply must in increase to meet higher demand r Causes AD to shift outwards (Dd pull inflation)

r*

Eo

E1
Qd Qd (P1) (P0)

MS0

MS1

Q Money

Higher MS

38

2

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3.

Starting from a point of equilibrium, explain what happens to inflation where there is a one-off rise in the price of oil but the monetary authorities do not accommodate the shock. (4) A rise in the price of oil is a negative supply shock This has the effect of shifting SRAS to the left. a. The price level rises, output falls, b. This causes a recessionary gap. c. A recessionary gap means that factors of production are being underutilized. With no monetary accommodation, (a well working) market will put pressure on factor costs to decrease, including wages. When this happens the SRAS shifts gradually to the right until output returns to potential GDP. At the same time the price level falls. In the long run the economy returns to its original point of

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