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Business Fluctuations: Work It Out 3 of 3 From the equation of exchange, M V = P Y , we know that spending growth ( −→ M + → v ) equals inflation π + Real growth. Recall from the chapter that in the long run (1) the inflation rate is found where the AD curve intersects the LRAS curve (reading off the vertical axis) and (2) the expected inflation rate is found where the short-run aggregate supply curve intersects the LRAS curve. With these things in mind, assume that the Solow growth rate is 3%. If spending growth equals 4%, what will π equal in the long run? What will E π equal?

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abdullahfarooqi

Answer:

Solow growth rate = growth rate of long run real GDP on LRAS = 3%.

Spending growth rate = 10%. Hence rate of inflation is 10% - 3% = 7%. This is because AD meets LRAS to determine a combination of Solow growth rate and inflation rate.

In the long run SRAS meets LRAS as well as AD. Hence, rate of inflation in long run equals the rate of expected inflation. Thus expected inflation is also 7%.

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