We€™ve just reviewed the quantity theory, which is a theory that shows how the economy fixed itself in the long run. But as economist John Maynard Keynes famously said, €œIn the long run we are all dead.€ Let€™s bring SRAS back into the model, and play the role of a central banker reacting to a rise in velocity growth.
a. The following diagram shows the economy growing at the potential growth rate with 10% inflation. Illustrate what happens if consumers and investors become more optimistic. Clearly label the new growth rate on the x-axis with the words €œHigh-AD real growth,€ and label the new inflation rate on the y-axis with the words €œHigh-AD inflation.€

b. Once the central banker sees this rise in AD, she decides to fully reverse it with monetary policy. In the graph, illustrate what happens if she does her job €œJust right.€
c. If she does her job €œJust right,€ what will the inflation rate be? Provide an exact number.

Solow growth rate Inflation rate SRAS(ETT-1096) AD (M + -13%) Real GDP growth rate