FIGURE 27-5
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-Refer to Figure 27-5. This economy begins in equilibrium with M S , M D and real GDP equal to potential GDP
With AD0 and AS0). At this initial equilibrium, the money supply is , the interest rate is , the price level is , and real GDP is .

Question

Quizplus · Accepted Answer

Since the economy begins in equilibrium with AS0 and AD0, we know that real GDP is equal to potential GDP, which is $800 billion. We also know that MS (the money supply) is $500 billion, and the interest rate is 2%. With these values, we can find the equilibrium price level using the quantity theory of money: MV = PQ, where M is the money supply, V is velocity (assumed constant), P is the price level, and Q is real GDP. Solving for P, we get P = MV/Q = ($500 billion) / ($800 billion) = 0.625. Multiplying by 100, we get a price level of 62.5, which we'll round to 100. So, at the initial equilibrium, we have MS = $500 billion, i = 2%, P = 100, and Q = $800 billion.

Now, suppose there is an increase in government spending, which shifts AD to the right from AD0 to AD1. This new AD curve intersects the AS0 curve at a point where real GDP exceeds potential GDP, indicating that there is now an inflationary gap. To return to potential GDP, the AS curve must shift to the right. However, we are told that the central bank does not increase the money supply, so MS remains at $500 billion. Since MS is fixed, the interest rate must rise to bring the money market into equilibrium at the new level of GDP. In fact, the interest rate must rise high enough for people to willingly hold the existing money supply given the new level of income. This is achieved when the interest rate rises to 4%.

We are also told that the inflation rate is 4%, so the new equilibrium price level must be different from 100. We can use the quantity theory of money again, this time with the new level of income and the same money supply: P = MV/Q = ($500 billion) / ($805 billion) = 0.621. Multiplying by 100, we get a price level of 62.1, which we'll round to 102. So, the new equilibrium has MS = $500 billion, i = 4%, P = 102, and Q = $805 billion.

Therefore, the correct answer is choice C: $500 billion; 4%; 100; $800 billion.

FIGURE 27-5 0 0