Consider an AD-AS model with AD curve 𝑌 − 𝑌 ∗ = −𝛼𝛾(𝜋 − 𝜋 ∗ ) + 𝜀" and AS curve𝜋 = 𝜋 # + 𝜙𝛽(𝑌 − 𝑌 ∗ ) + 𝜀$ with parameter values 𝛼 = 𝜙 = 0.5 and 𝛾 = 𝛽 = 2 andwith inflation target 𝜋 ∗ = 0.03 and potential output normalised to 𝑌 ∗ = 1. Startingfrom a long-run equilibrium with 𝜋 # = 𝜋 ∗ suppose there is a temporary supply shock𝜀$ = −0.06. Which of the following is TRUE?a. In the short run, inflation is 1%b. In the long run, inflation is 0%c. In the short run, output is 6% below potentiald. In the short run output is 3% above potential

To answer this question, we need to understand the AD-AS model and how it reacts to shocks.

The AD-AS model is a macroeconomic model that explains price level and output through the relationship of aggregate demand (AD) and aggregate supply (AS).

Given the equations for the AD and AS curves, we can substitute the given values into these equations to find the new equilibrium after the supply shock.

1. First, let's consider the AS curve after the shock. The AS curve is given by 𝜋 = 𝜋 # + 𝜙𝛽(𝑌 − 𝑌 ∗ ) + 𝜀$. Substituting the given values, we get 𝜋 = 0.03 + 0.52(𝑌 − 1) - 0.06. Simplifying this, we get 𝜋 = -0.03 + 𝑌.

2. Now, let's consider the AD curve. The AD curve is given by 𝑌 − 𝑌 ∗ = −𝛼𝛾(𝜋 − 𝜋 ∗ ) + 𝜀. Since we are in a long-run equilibrium, 𝜀 = 0. Substituting the given values, we get 𝑌 − 1 = -0.52(𝜋 - 0.03). Simplifying this, we get 𝑌 = -𝜋 + 1.03.

3. To find the new equilibrium, we set the two equations equal to each other: -0.03 + 𝑌 = -𝜋 + 1.03. Solving for 𝑌, we get 𝑌 = 1 - 0.06 = 0.94. This means output is 6% below potential, so option c is correct.

4. Substituting 𝑌 = 0.94 into the AS equation, we get 𝜋 = -0.03 + 0.94 = 0.91, or 91%. This means neither option a nor b is correct.

5. Since output is below potential, it cannot be above potential, so option d is also incorrect.

Therefore, the correct answer is c. In the short run, output is 6% below potential.