Consider the following short run aggregate supply equation: Y= $ \hat{\mathrm{Y}} $ + b (P - P^e), where Y is the real output, $ \hat{\mathrm{Y}} $ is the full employment output, P and P^eare the actual and expected price levels, respectively^. Which of the following is correct? A) In the classical model, P is always equal to P^ebecause of price misperception assumption. B) In the classical model, P may be different than P^ebecause of price misperception assumption. C) In the classical model, P is always greater than P^ebecause of price misperception assumption. D) In the classical model, P is always less than P^ebecause of price misperception assumption.

Question

Quizplus · Accepted Answer

In the classical model, firms have imperfect information about the actual price level and base their production decisions on their expectations about the price level, represented by P^e. Due to this price misperception assumption, the actual price level, P, may be different than the expected price level, P^e, leading to a short-run adjustment period. Therefore, choice B is correct as P may be different than P^edue to the price misperception assumption in the classical model.

Consider the Following Short Run Aggregate Supply Equation: Y= Y^ \hat{\mathrm{Y}} Y^

Consider the Following Short Run Aggregate Supply Equation: Y= $\hat{\mathrm{Y}}$