Question -
Consider the following model of the economy:
Wages are determined by the following equation W = Pe (2.5 - 10u)
Price is determined by the following equation
Production function.
Labour force is fixed
Consumption function +0.5(Y-T)
Investment function I +0.3Y-100 i
Government spending
Taxes
The central bank is using the following Interest Rate Rule: it = in + 2(P-PT)
Where
a. Derive the AS relationship for this economy. What are the natural rate of unemployment and the natural level of output?
b. Derive the IS relationship for this economy.
c. Derive the AD relationship for this economy
d. What are the medium run values of P, Y and i?
e. Analyse qualitatively what will happen to the economy in the short run and the medium run if the central bank decides to increase its price target from 10 to 20? Assume that the expected price for the next period is equal to the current price. Use a diagram in your answer.