Econ 102-Last problem set

What causes the economy to move from its short-run equilibrium to its long-run equilibrium?

Nominal wages, prices, and perceptions adjust upward to this new price level.

Which of the following reasons could explain why the aggregate quantity of output supplied changes?

Prices are sticky. The price level has risen. People have misperceptions about the price level.

In the long run, an economy's output of goods and services depends on...

its supplies of labor, capital, and natural resources and on the technology used to transform factors of production into goods and services. Thus, anything that changes any of these determinants will cause the long-run aggregate supply to shift.

A change in the expected price level shifts

the short-run aggregate-supply curve, but not the long-run aggregate-supply curve. If people expect lower prices in the future, they will accept lower wages (that is, supply more labor for any given price level) and set lower prices (or produce more output at any given price level). This would be reflected in a rightward shift of the short-run aggregate-supply curve. The long-run aggregate-supply curve, on the other hand, is not affected by a change (either real or expected) in the price level, since the price level (a nominal variable) does not affect the supply of goods and services in the long run.

Effect on LRAS A severe hurricane damages factories along the East Coast.

Decrease

An increase in the aggregate demand for goods and services has a larger impact on output ________ and a larger impact on the price level ________.

Short run Long run

Real exchange rate effect

The tendency for a fall in the price level to decrease the real exchange rate and increase net exports

Temporary or permanent The__policy will stimulate greater spending by consumers. The___ policy will have the greater impact on aggregate demand.

Permanent Permanent A tax cut that is permanent will have a bigger impact on consumer spending and aggregate demand. If the tax cut is permanent, consumers will view it as adding substantially to their financial resources, and they will increase their spending substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they will not increase spending as much.

According to the sticky-wage theory of aggregate supply, nominal wages at the initial equilibrium are__nominal wages at the short-run equilibrium resulting from the increase in the money supply, and__nominal wages at the long-run equilibrium. Real wages at the initial equilibrium are__ real wages at the short-run equilibrium resulting from the increase in the money supply, and__real wages at the long-run equilibrium. Judging by the impact of the money supply on nominal and real wages, this analysis__consistent with the proposition that money has real effects in the short run but is neutral in the long run.

Equal to Less than Greater than Equal to is

Multiplier

1/(1-MPC) Multiply this by original to see total

If the central bank wants to expand aggregate demand, it can ________ the money supply, which would ________ the interest rate.

Increase Decrease An increase in the money supply shifts the money-supply curve to the right. Because the money-demand curve has not changed, the interest rate falls to balance money supply and money demand. That is, the interest rate must fall to induce people to hold the additional money the Fed has created, restoring equilibrium in the money market.

During the transition from the short run to the long run, price-level expectations wil___ and the___curve will shift to the__

Adjust downward Short run aggregate supply Right 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 $600 billion, before the decrease in investment spending associated with business pessimism.

It is a function of disposable income.

C

Effect on LRAS Congress raises the minimum wage to $15 per hour.

Decrease

In the long run, as a result of the business pessimism, the price level___ , the quantity of output___he natural level of output, and the unemployment rate___t the natural rate of unemployment.

Decrease Decrease Returns to

The aggregate quantity of output demanded___ between the short run and the long run because the price level___

Decreases Rises

In the short run, the decrease in investment spending associated with business pessimism causes the price level to___the price level people expected and the quantity of output to___ the natural level of output. The business pessimism will cause the unemployment rate to___ the natural rate of unemployment in the short run.

Fall below Fall below Rise above In the short run, the decrease in investment spending associated with business pessimism causes the aggregate demand curve to shift to the left, resulting in a lower-than-expected price level (100) and a quantity of output ($500 billion) that falls short of the natural level of output. The decrease in production causes firms to lay off workers, so the unemployment rate will rise above the natural rate of unemployment.

Would the effect on aggregate demand be larger if the Federal Reserve held the money supply constant in response, or if the Fed were committed to maintaining a fixed interest rate?

Fixed interest rate If government spending increases, aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in the interest rate and, thus, a decline in aggregate demand if the Fed keeps the money supply constant. But if the Fed maintains a fixed interest rate, it will increase the money supply, so aggregate demand will not decline. Thus, the effect on aggregate demand from an increase in government spending will be larger if the Fed maintains a fixed interest rate.

It is an autonomous amount, independent of other factors.

G T

It depends on the interest rate.

I

Suppose the Fed announces that it is lowering its target interest rate by 75 basis points, or 0.75 percentage point. To do this, the Fed will use open-market operations to__the__t money by __ from the public_

INcreaae Supply Buying bonds from

Change needed to increase AD Consumer expectations about future profitability

INcrease Consumer spending is influenced, in part, by consumer expectations. If households expect strong economic growth and higher earnings, they will spend more today. The increase in current consumption causes an increase in aggregate demand at each price level.

Monetary neutrality

In the long run, an increase in the money supply causes an increase in the nominal wage but leaves the real wage unchanged

Effect on LRAS Intel invents a new and more powerful computer chip.

Increase

The United States experiences a wave of immigration. effect on LRAS

Increase

Change needed to increase AD Government spending

Increase Because government purchases are one component of aggregate demand, an increase in government spending causes aggregate demand to increase at each price level.

Change needed to increase AD Expected rate of return on investment

Increase The rate of return that businesses expect on capital projects is a key determinant of investment. Suppose a technological breakthrough causes an increase in the expected return on investment. Investment spending will rise, and aggregate demand will increase at each price level.

Change needed to increase AD Incomes in other countries

Increase When the incomes of foreigners increase, foreigners will purchase more domestic products, causing exports to rise. Because net exports are one component of aggregate demand, this increase in net exports (exports minus imports) leads to an increase in aggregate demand at each price level.

he Fed's policy of targeting a lower interest rate will__ the cost of borrowing, causing residential and business investment spending to__and the quantity of output demanded to __ at each price level.

Reduce Increase Increase Firms will increase spending on factories, office buildings, machinery, tools, and equipment. Households will increase spending on new homes. As overall investment spending increases, in turn leading to higher consumer spending through the multiplier, the quantity of output demanded increases at each price level. The increase in the money supply and the correspondingly lower interest rate cause the aggregate demand curve to shift to the right.

This new chair is well known for her view that inflation is not a major problem for an economy. As a result of this news, people will expect the price level to___ , which, in turn, will cause the nominal wage that workers and firms agree to in their new labor contracts to be___than it would be otherwise. This___ the profitability of producing goods and services at any given price level, which would cause the short-run aggregate-supply curve to shift to the___ . If aggregate demand is held constant, this shift in the aggregate-supply curve will cause the price level to___ and the quantity of output produced to___ .

Rise Higher DecreasesLeft Rise Fall People will likely expect that the new chair will not actively fight inflation, so they will expect the price level to rise. If people believe that the price level will be higher over the next year, workers will want higher nominal wages. At any given price level, higher labor costs lead to reduced profitability. The short-run aggregate-supply curve will shift to the left A decline in short-run aggregate supply leads to reduced output and a higher price level. This choice to ignore inflation and keep aggregate demand unchanged was probably not wise. The end result is stagflation, which provides limited choices in terms of policies to remedy the situation

Suppose the government increases its purchases by $1,200 while holding the money supply constant. The change in aggregate demand resulting from an increase in government purchases if the government allows interest rates to adjust (as compared to the change if it were to hold them constant) will be

Smaller but positive As an increase in government spending increases aggregate demand, the demand for money increases as well. If the money supply is held constant, this leads to higher interest rates. Higher interest rates dampen private investment spending, one of the components of aggregate demand. This is known as the crowding-out effect, the result of which is a smaller, but still positive, increase in aggregate demand after an increase in government purchases.

Additionally, as the price level falls, the impact on the domestic interest rate will cause the real value of the dollar to___in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore___, and the number of foreign products purchased by domestic consumers and firms (imports) will___. Net exports will therefore___ , causing the quantity of domestic output demanded to___ This phenomenon is known as the___

fall rise fall rise rise exchange rate effect When an economy's price level falls, consumers require less money to purchase a given basket of goods and services, so that money demand falls, causing the domestic interest rate to fall. Investors respond to lower domestic interest rates by seeking higher returns abroad. As domestic investors attempt to convert dollars into foreign currency to buy foreign assets, the supply of dollars increases in the market for foreign-currency exchange, and the real value of the dollar falls. When each dollar buys fewer units of foreign currencies, foreign goods become more expensive than domestic goods. Because of dollar depreciation, foreigners find domestic goods to be relatively inexpensive. Exports of domestic goods to foreigners therefore rise, while domestic imports of foreign goods fall. Net exports (exports minus imports) therefore rise, leading to a rise in the quantity of domestic output demanded.

Stagflation

is a period of time where output is falling and prices are rising. When firms experience an increase in the costs of production, selling goods becomes less profitable, and firms supply less output at any given price level. This causes the aggregate-supply curve to shift to the left, resulting in lower output and a higher price level

The investment boom might cause the long-run aggregate-supply curve to shift to the__ if it results in a larger capital stock that increases productivity and output in the future.

right The investment boom might increase long-run aggregate-supply because higher investment today means a larger capital stock in the future and thus higher productivity and output

As the price level falls, the purchasing power of households' real wealth will__, causing the quantity of output demanded to___. This phenomenon is known as the___effect.

rise rise wealth According to the wealth effect, decreases in the price level increase the quantity of output demanded.

A sudden crash in the stock market shifts

the aggregate-demand curve. any event that causes consumers to cut back on spending and firms to cut back on their investment, reduces aggregate demand at any given price level (that is, causes a leftward shift of the aggregate-demand curve)