Question: We've just reviewed the quantity theory of money, which is a theory that shows how the economy fixes itself in the long run. But as economist John Maynard Keynes famously said, "In the long run we are all dead." Let's bring SRAS back into the model, and play the role of a central banker reacting to a rise in velocity growth.
a. The following diagram shows the economy growing at the potential growth rate with 10% inflation. Illustrate what happens if consumers and investors become more optimistic. Clearly label the new growth rate on the x-axis with the words "High AD real growth," and label the new inflation rate on the y-axis with the words "High-AD inflation."
b. Once the central banker sees this rise in AD, she decides to fully reverse it with monetary policy. In the graph, illustrate what happens if she does her job "Just right."
c. If she does her job "Just right," what will the inflation rate be? Provide an exact number.