Aggregate Demand and Supply Analysis

-In the figure above, assume that output is $10.5 trillion, while potential output is $12 trillion. Suppose that a combination of fiscal stimulus and recovery of consumer and business confidence shifts the IS and AD curves, as shown in the figure, while monetary policy sets the real interest rate at one percent. If the short-run aggregate supply curve is π = Y - 13, then the resulting values of output and inflation are ________.
A) $12 trillion & 3 percent
B) $13.5 trillion & 5 percent
C) $9.75 trillion & 0 percent
D) $13.5 trillion & 0 percent
E) $12.5 trillion & 2 percent

Question

Aggregate Demand and Supply Analysis
 
-In the figure above, assume that output is $10.5 trillion, while potential output is $12 trillion. Suppose that a combination of fiscal stimulus and recovery of consumer and business confidence shifts the IS and AD curves, as shown in the figure, while monetary policy sets the real interest rate at one percent. If the short-run aggregate supply curve is π =  Y - 13, then the resulting values of output and inflation are ________.
A) $12 trillion & 3 percent 
B) $13.5 trillion & 5 percent 
C) $9.75 trillion & 0 percent 
D) $13.5 trillion & 0 percent 
E) $12.5 trillion & 2 percent

Quizplus · Accepted Answer

Given, output = $10.5 trillion, potential output = $12 trillion, and short-run aggregate supply curve is π = 11eab3ba_70ff_9bec_a5fb_4f727eea88a6_TB5034_11 Y - 13.
The intersection of AD and SRAS curves determines the level of output and inflation. Here, AD curve has shifted rightward due to fiscal stimulus and recovery of confidence, leading to an increase in output.
The equation of AD curve is AD = C + I + G + NX. Monetary policy sets the real interest rate at one percent, which decreases saving and increases investment (as investment becomes cheaper). So, the value of C, I, and NX in the AD equation increases, shifting the AD curve to the right.
At the new equilibrium, output is higher than the initial level but below potential output, and inflation is higher than the initial level.
Putting the given values in the short-run aggregate supply curve, we get:
π = 11eab3ba_70ff_9bec_a5fb_4f727eea88a6_TB5034_11 Y - 13
π = 11eab3ba_70ff_9bec_a5fb_4f727eea88a6_TB5034_11× $10.5 trillion - 13
π = $2.04 trillion
Therefore, the output is $13.5 trillion ($10.5 trillion + $2 trillion) and inflation is 5 percent ($2.04 trillion/$10.5 trillion x 100). Thus, the correct answer is B.