Econ: Chapter 15

9. Economic fluctuations II (con. 2)

explanation

6. Why the aggregate supply curve slopes upward in the short run (con.)

for the graph

9. Economic fluctuations II (con. 2)

ow suppose that the government decides not to take any action in response to the short-run economic impact of the higher oil prices. In the long run, when the government does nothing, the output in the economy will be $80billion and the price level will be 80.

8. Economic fluctuations I - part 2

- Again, the following graph shows the economy in long-run equilibrium at the expected price level of 120 and the natural level of output of $300 billion, before the decrease in investment spending associated with business pessimism. - During the transition from the short run to the long run, price-level expectations will adjust downward and the short-run aggregate supply curve will shift to the right. -Now show the long-run impact of the business pessimism by shifting both the aggregate demand (AD) curve and the short-run aggregate supply (AS) curve to the appropriate positions. (graph) - In the long run, as a result of the business pessimism, the price level decreases , the quantity of output returns to the natural level of output, and the unemployment rate returns to the natural rate of unemployment.

6. Why the aggregate supply curve slopes upward in the short run

- In the short run, the quantity of output that firms supply can deviate from the natural level of output if the actual price level in the economy deviates from the expected price level. Several theories explain how this might happen. - For example, the sticky-wage theory asserts that output prices adjust more quickly to changes in the price level than wages do, in part because of long-term wage contracts. Suppose a firm signs a contract agreeing to pay its workers $15 per hour for the next year, based on an expected price level of 100. If the actual price level turns out to be 110, the firm's output prices will rise , and the wages the firm pays its workers will remain fixed at the contracted level. The firm will respond to the unexpected increase in the price level by increasing the quantity of output it supplies. If many firms face similarly rigid wage contracts, the unexpected increase in the price level causes the quantity of output supplied to rise above the natural level of output in the short run. --- Refers to the Graph --- - Suppose the economy's short-run aggregate supply (AS) curve is given by the following equation: Quantity of Output Supplied = Natural Level of Output + α x (Price LevelActual−Price LevelExpected) - The Greek letter α represents a number that determines how much output responds to unexpected changes in the price level. In this case, assume that α=$4 billion. That is, when the actual price level exceeds the expected price level by 1, the quantity of output supplied will exceed the natural level of output by $4 billion. - Suppose the natural level of output is $40 billion of real GDP and that people expect a price level of 110. - On the following graph, use the purple line (diamond symbol) to plot this economy's long-run aggregate supply (LRAS) curve. Then use the orange line segments (square symbol) to plot the economy's short-run aggregate supply (AS) curve at each of the following price levels: 100, 105, 110, 115, and 120. - The short-run quantity of output supplied by firms will rise above the natural level of output when the actual price level rises above the price level that people expected.

2. Explaining short-run economic fluctuations

- Most economists believe that real economic variables and nominal economic variables behave independently of each other in the long run. -For example, an increase in the money supply, a nominal variable, will cause the price level, a nominal variable, to increase but will have no long-run effect on the quantity of goods and services the economy can produce, a real variable. The distinction between real variables and nominal variables is known as the classical dichotomy. --- (Refers to the graph) - - In the short run, however, most economists believe that real and nominal variables are intertwined. Economists use the model of aggregate demand and aggregate supply to examine the economy's short-run fluctuations around the long-run output level. The following graph shows an incomplete short-run aggregate demand (AD) and aggregate supply (AS) diagram—it needs appropriate labels for the axes and curves. You will identify some of the missing labels in the questions that follow. - The vertical axis of the aggregate demand and aggregate supply model measures the overall price level. - The aggregate demand curve shows the quantity of output that households, firms, the government, and foreign customers want to buy at each price level.

5. The slope and position of the long-run aggregate supply curve

- Suppose the Fed doubles the growth rate of the quantity of money in the economy. In the long run, the increase in money growth will change which of the following? The inflation rate and the price level. --- Refers to the Graph --- - Suppose the economy produces real GDP of $60 billion when unemployment is at its natural rate. --- - Suppose the government passes a law that significantly increases the minimum wage. The policy will cause the natural rate of unemployment to rise, which will: Shift the long-run aggregate supply curve to the left. - In the following list, determine how each event affects the position of the long-run aggregate supply (LRAS) curve: The government allows more immigration of working-age adults who find work - right For environmental and safety reasons, the government requires that the country's nuclear power plants be permanently shut down - left An investment tax credit increases the rate at which firms acquire machinery and equipment - right

1. Key Factors about economic fluctuations

- The following graph approximates business cycles in the United States from the first quarter of 1947 to the third quarter of 1951. The vertical blue bar coincides with periods of 6 or more months of declining real gross domestic product (real GDP). - Notice that real GDP trends upward over time but experiences ups and downs in the short run. A period of declining real GDP, such as the blue-shaded period in 1948, is known as a recession. -True or False: Small ups and downs in real GDP follow a consistent, predictable pattern. - Which of the following probably occurred as the U.S. economy experienced increasing real GDP in 1950? Check all that apply: Consumer spending increased and the unemployment rate declined.

7. Determinants of aggregate supply

- The following graph shows a decrease in short-run aggregate supply (AS) in a hypothetical economy where the currency is the dollar. Specifically, the short-run aggregate supply curve shifts to the left from AS1 to AS2, causing the quantity of output supplied at a price level of 100 to fall from $200 billion to $150 billion. - The following lists several determinants of short-run aggregate supply. Change Needed to Decrease AS - Input Prices: increase - Tax Rates: increase - Burdensome Regulations: increase

4. Determinants of aggregate demand

- The following graph shows an increase in aggregate demand (AD) in a hypothetical country. Specifically, aggregate demand shifts to the right from AD1 to AD2, causing the quantity of output demanded to rise at all price levels. For example, at a price level of 140, the output is now $400 billion, where previously it was $300 billion. - Changed Needed to Increase AD: Consumer expectations about future profitability - improve, Government spending - increase, Expected rate of return on investment - increase, Incomes in other countries - increase

3. Why the aggregate demand curve slopes downward

- The following graph shows the aggregate demand (AD) curve in a hypothetical economy. At point A, the price level is 140, and the quantity of output demanded is $300 billion. Moving down along the aggregate demand curve from point A to point B, the price level falls to 120, and the quantity of output demanded rises to $500 billion. -As the price level falls, the cost of borrowing money will fall, causing the quantity of output demanded to rise. This phenomenon is known as the interest rate effect. - Additionally, as the price level falls, the impact on the domestic interest rate will cause the real value of the dollar to fall in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore rise, and the number of foreign products purchased by domestic consumers and firms (imports) will fall. Net exports will therefore rise, causing the quantity of domestic output demanded to rise. This phenomenon is known as the exchange rate effect.

8. Economic fluctuations I - part 1

- The following graph shows the economy in long-run equilibrium at the expected price level of 120 and the natural level of output of $300 billion. Suppose firms become pessimistic about future business conditions and cut back on investment spending. - Shift the short-run aggregate supply (AS) curve or the aggregate demand (AD) curve to show the short-run impact of the business pessimism. (graph) - In the short run, the decrease in investment spending associated with business pessimism causes the price level to fall below the price level people expected and the quantity of output to fall below the natural level of output. The business pessimism will cause the unemployment rate to rise above the natural rate of unemployment in the short run.

9. Economic fluctuations II

- The following graph shows the short-run aggregate supply curve (AS), the aggregate demand curve (AD), and the long-run aggregate supply curve (LRAS) for a hypothetical economy. Initially, the expected price level is equal to the actual price level, and the economy is in long-run equilibrium at its natural level of output, $80 billion. - Suppose war in the world's main oil-producing region sharply reduces the world oil supply, causing oil prices to rise and increasing the costs of producing goods and services in this economy. - Use the graph to help you answer the questions about the short-run and long-run effects of the increase in production costs that follow. (Note: You will not be graded on any adjustments made to the graph.) - The short-run economic outcome resulting from the increase in production costs is known as stagflation