Inflation in the Economy 1 Consider a closed economy whose aggregate demand is described by the NIPA equation: Y=C+I+G where the individual components of the NIPA equation are given by CIG=C+mpc(YT)=Iv(r+)=G Note that in this economy, consumption and investment spending respond to the nominal interest rate (i r+). In this economy, short-run aggregate supply is given by =(YYN)+ Long-run aggregate supply is fixed at Y=YN. a (20 points) Plot the short-run aggregate supply, long-run aggregate supply, and aggregate demand curves and show the dynamics of (i) a negative permanent supply shock (YN); (ii) a negative temporary supply shock () and a positive demand shock (C) that occur simultaneously. Do this in two separate graphs that show the dynamics of aggregate supply and demand. (this requires no math and does not involve the equations above). What happens to inflation in each case? b (10 points) Derive the aggregate demand equation using the NIPA equation as well as the consumption function, investment function and the level of government spending. c (20 points) Suppose the following values: C=120,I=50,T=50,G=50,mpc=0.6,v=50. If C decreases to 110 , by how much will output decrease in the short-run? d (30 points) Now suppose that consumption decisions depend on the rate of inflation. Consumers do not like to consume when prices go up, meaning that the consumption function is given by C=C+mpc (YT)h. This yields the following system of equations that determine aggregate demand: CIG=C+mpc(YT)h=Iv(r+)=G Do the following (parts e and f) : e (10 points) Derive the new aggregate demand equation. f (20 points) Suppose that supply is always at its long-run level, Y=YN and =. Starting from =0, show graphically what would happen if increases and supply does not adjust (ie Y stays at YN ). Be sure to show or describe how much total private consumption (C) changes as inflation () changes