Consider the following closed economy where natural level of output (Y ) is 1200. Suppose aggregate demand is given by the following equation, P = 2000 Y

(a) What is the long-run price level and level of output?

(b) Consider the sticky price model where flexible firms set the price following, p = P + a(Y Y ) and firms with sticky prices follow p' = EP + aE(Y Y ) where a = 2, E(Y Y ) = 0, EP = 1, and as stated above, Y = 1200. The fraction of firms with sticky prices, s, is 0.75. Derive the short-run AS curve.

(c) Suppose the government pursues expansionary policy which shifts the aggregate demand curve to P = 2200 Y . Compute the new short-run equilibrium values Y and P.

(d) Will the above equilibrium (computed in (c)) persist indefinitely? What will the longrun values of P and Y be? Explain your rationale.