
(a)
The equations for dynamic aggregative
(a)

Explanation of Solution
The equation for the expected inflation with respect to random shocks in period
Here,
The equation for the dynamic aggregative supply (DAS) curve with the presence of random shocks can be derived as follows.
Consider the
The equation for Philips curve:
Now, substitute Equation (1) in Equation (3) to get the equation for DAS curve.
Therefore, the Philips curve becomes
The equation for DAD curve can be derived by using the following equations in the dynamic AD-AS model:
The equation for the demand for goods and services:
The fisher equation:
Consider Equation (5).
Substitute Equation (6) into Equation (5).
Now, substitute Equation (2) instead of
Consider the monetary policy rule in the dynamic AD-AS model.
The equation for the monetary-policy rule.
Substitute Equation (8) in Equation (7).
Now, rearrange the above equation to get the equation for DAD curve.
Therefore, the equation for the DAD curve can be represented as follows:
Dynamic aggregative demand curve: The dynamic aggregative demand curve indicates the negative association between output and inflation which determines the economy’s short-run equilibrium.
Dynamic
(b)
Explain the effect of random shock if it is greater than zero on DAD, DAS, output level, inflation rate, nominal interest rate, and real interest rate.
(b)

Explanation of Solution
The DAD curve shows the relationship between output and inflation. Therefore, the value of random shock is greater than zero, which causes to shift the DAD curve right ward. This rightward shift of DAD curve increases the rate of inflation and output level. In such situation, according to the
Dynamic aggregative demand curve: The dynamic aggregative demand curve indicates the negative association between output and inflation which determines the economy’s short-run equilibrium.
Dynamic aggregative supply curve: The dynamic aggregative supply curve indicates positive association between output and inflation which determines the economy’s short-run equilibrium.
(c)
The changes in DAD, DAS, output, inflation, nominal, and real interest rate in period
(c)

Explanation of Solution
As described in part (a), in period
Here,
Stagflation: The stagflation is an economic condition where slow
(d)
The changes in subsequent periods.
(d)

Explanation of Solution
As described in part (c), in period
Dynamic aggregative supply curve: The dynamic aggregative supply curve indicates one of the two relationships between output and inflation which determines the economy’s short-run equilibrium.
(e)
The statement that inflation scares self- fulfilling.
(e)

Explanation of Solution
As described in part (b), if the value of random shock is greater than zero, it causes to shift the DAD curve rightward. This rightward shift of DAD curve increases the rate of inflation and output level. This means when people expect a higher inflation, such type of random shocks act in a way that it actually does. Therefore, the given analysis illustrates that the inflation scares can be self-fulfilling.
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