econ quiz 5

In the short run, prices may rise faster than costs. This chapter discusses why this might happen. Suppose that labor and management agree to adjust wages continuously for any changes in the price level. How would such adjustments affect the slope of the aggregate supply curve?

Because some resource prices are fixed in the short run, increases in output do not cause the price level to rise as fast as it otherwise might. However, if wages were indexed to movements in the price level, the short-run aggregate supply curve would have a greater slope, approaching that of the potential output curve. Every time the price level rose, the resulting increase in wages would bring additional pressure to bear, making it difficult to increase output without a substantial increase in prices. The main point to emphasize here, as the text notes, is that the stickiness of some resource prices flattens out the short-run aggregate supply curve.

What factors can cause the consumption function to shift?

net wealth, price level, interest rate, and consumer expectations. A change in any of these factors will shift the consumption function.

13. (Simple Spending Multiplier) For each of the following values for the MPC, determine the size of the simple spending multiplier and the total change in real GDP demanded following a $10 billion decrease in spending:

. The multiplier equals 10; real GDP falls by $100 billion. b. The multiplier equals 4; real GDP falls by $40 billion. c. The multiplier equals 2.5; real GDP falls by $25 billion.

Unemployment is costly to employers, employees, and the economy as a whole. What are some explanations for the coordination failures that prevent workers and employers from reaching agreements?

A coordination failure occurs when workers and employers fail to achieve an outcome that all would prefer. Long-term contracts, wages, the difficulty of coordinating a wage cut on a large scale, and the existence of generous unemployment benefits contribute to coordination failure.

Discuss some instances in your life when your actual production for short periods exceeded what you considered your potential production. Why does this occur only for brief periods?

As a student, you study for long periods during exam week and exceed your normal study time. For a short period of time, you can study for 14 to 18 hours per day. You could not keep up this pace for longer than a brief period. This example is similar to the economy producing beyond its potential output for an extended period of time. Triple shifts and overtime cannot go on forever. The employees become burned out.

Why would the following investments increase as the interest rate declines?

As interest rates fall, holding revenue from the use of the equipment constant, it becomes easier to finance the purchase of new plants and equipment. b. With lower interest rates, mortgage rates fall. This induces more individuals to consider building new houses. c. Lower interest rates mean that an expansion of less productive, less profitable inventories can be financed more easily. This will cause firms to be more willing and able to expand inventories.

Why do economic forecasters pay special attention to investment plans? Take a look at the Conference Board's index of leading economic indicators at http://www.conference-board.org/. Which of those indicators might affect investment?

Consumption, while the largest component of aggregate spending, is fairly stable. Therefore, it is less likely to cause significant swings in aggregate output. In contrast, investment spending is much more volatile relative to both consumption and GDP. Investment accounts for much of the variability in real GDP.

11. (Long-Run Aggregate Supply) The long-run aggregate supply curve is vertical at the economy's potential output level. Why is the long-run aggregate supply curve located at this output rather than below or above potential output?

Cyclical unemployment is a disequilibrium phenomenon that results from the lack of perfect foresight on the part of firms and resource suppliers. Movements away from potential output can occur only in the short run if there are no other disturbances to the system. Thus, the long-run aggregate supply curve should be vertical at the economy's potential level of output. To have the long-run aggregate supply curve vertical at any other output level would imply long-lasting cyclical unemployment or a labor shortage.

What is the relationship between potential output and the natural rate of unemployment? a. If the economy currently has a frictional unemployment rate of 2 percent, structural unemployment of 2 percent, seasonal unemployment of 0.5 percent, and cyclical unemployment of 2 percent, what is the natural rate of unemployment? Where is the economy operating relative to its potential GDP? b. What happens to the natural rate of unemployment and potential GDP if cyclical unemployment rises to 3 percent with other types of unemployment unchanged from part (a)? c. What happens to the natural rate of unemployment and potential GDP if structural unemployment falls to 1.5 percent with other types of unemployment unchanged from part (a)?

Given the levels of the different types of unemployment, the natural rate of unemployment would be 4.5 percent, and the economy would have an actual real GDP below its potential GDP. b. An increase in cyclical unemployment has no effect on the natural rate of unemployment or potential GDP. c. A decrease in structural unemployment results in a decrease in the natural rate of unemployment to 4.0.

10. (Long-Run Adjustment) In the long run, why does an actual price level that exceeds the expected price level lead to changes in the nominal wage? Why do these changes cause shifts of the short-run aggregate supply curve?

If the actual price level is below the expected level, contracts drawn up by workers and firms have set too high a nominal wage. When the time for renegotiation of the wage comes around, firms will expect a lowering of the money wage to conform with the equilibrium real wage. As the money wage falls, the short-run aggregate supply curve will shift to the right, returning output to its potential level. The aggregate supply curve shifts because it is drawn assuming that at least some resource prices are fixed. If the money wage decreases, it becomes more profitable to expand output, and so the aggregate supply curve shifts to the right.

15. (Investment and the Multiplier) This chapter assumes that investment is independent of the income level in the economy. What would happen to the size of the multiplier if investment increases as real GDP increases? Explain.

If the investment line had a positive slope, the aggregate expenditure line would be steeper. The result would be a larger multiplier.

What is the effect of a lower price level, other things constant, on the aggregate expenditure line and real GDP demanded?

If the price level falls, real wealth rises, the market interest rate falls, and foreign goods become relatively expensive. Therefore, consumption, investment, and net exports rise, all of which shift the aggregate expenditure line upward. Equilibrium real GDP demanded rises as well.

How does an economy that is experiencing an expansionary gap adjust in the long run?

In the long run, firms and workers realize that the actual price level exceeds the expected price level reflected in long-term contracts. Actual unemployment falls below the natural rate of unemployment, and labor shortages occur. When the resource payments are renegotiated, nominal wages and other resource prices rise, and the short-run aggregate supply curve shifts to the left. The process continues until actual prices equal expected prices, and the economy returns to potential output.

After reviewing Exhibit 3 in this chapter, explain why recessionary gaps occur only in the short run and only when the actual price level is below what was expected.

In the long run, the actual and expected price levels equal one another when potential output and actual output are equal. Thus, there is no pressure on prices to rise or fall. Recessionary gaps occur only when output is below its potential level and the price level is below its expected level. If this is the case, nominal wages will be too high, giving rise to unemployment and below-potential output. This in turn will produce pressure on labor and business to accept nominal wage cuts and lower prices, respectively. In Exhibit 3 we have the case of a reduction in aggregate demand causing the actual price level to be below that expected. This gives rise to an increase in aggregate supply and a change in expected price from 110 to 100.

What role do inventories play in determining the real GDP demanded? In answering this question, suppose initially that firms are either producing more than people plan to spend, or producing less than people plan to spend.

Inventories play an essential role in the establishment of macroeconomic equilibrium. Suppose that firms are currently overproducing. The managers of the firms will soon notice that inventories are piling up and will reduce production. Over time, inventories fall if the rate of spending exceeds the rate of production.

Define the economy's potential output. What factors help determine potential output?

Potential output is the maximum output sustainable in the long run, given the state of technology and know-how, and the quantity/quality of resources in the economy. Many factors affect the potential output of the economy. The first is the economy's stock of capital. An economy with a large stock of plants and machinery will produce more than one with a smaller stock. Second, we must consider the effect of the level of technology and know-how. The better the technology, the more output can be produced from a given stock of resources. Along with technology, one should point out that the stock of human capital in the economy is equally important. It is of no use to have computers and other sophisticated technology if there is no one who can effectively use them. Third, the level of potential output will depend on society's stock of natural resources. Fourth, improved size or quality of the labor force would increase potential output. Finally, the formal and informal institutions supporting the economy (such as types of labor contracts, enforcement of property rights and contracts, political stability) have an important effect on potential output.

Changes in Aggregate Supply) What are supply shocks? Distinguish between beneficial and adverse supply shocks. Do such shocks affect the short-run aggregate supply curve, the long-run aggregate supply curve, or both? What is the resulting impact on potential GDP?

Supply shocks are unexpected events that change aggregate supply, in contrast to gradual long-term changes that often occur due to population changes. Beneficial supply shocks increase aggregate supply, while adverse supply shocks decrease it. Supply shocks can generate either temporary or permanent changes in aggregate supply. Temporary changes (such as an isolated drought that affects agricultural yields) mean that only the short-run aggregate supply curve is affected; permanent changes (such as a sudden leap in technology) are reflected by shifts in both the short-run and long-run aggregate supply curves. Temporary changes have no impact on potential GDP, but permanent changes cause potential GDP to increase with a beneficial shock and decrease with an adverse shock.

What are the components of aggregate expenditure? In the model developed in this chapter, which components vary with changes in the level of income? What determines the slope of the aggregate expenditure line?

The components of aggregate expenditure are (a) consumption, (b) investment, (c) government purchases, and (d) net exports. Only consumption varies with the level of income; the other components are assumed to be autonomous. Therefore, the slope of the aggregate expenditure line is the slope of the consumption function and equals the MPC.

According to the life-cycle hypothesis, what is the typical pattern of saving and spending for an individual over his or her lifetime? What impact does this pattern have on the saving rate in the overall economy?

The life-cycle model of consumption of saving states that young people borrow, middle agers pay off debt and save, and older people draw down their savings; on average, net savings over a lifetime is usually little or nothing.

What equalities hold at the level of real GDP demanded? When determining real GDP demanded, what do we assume about the price level? What do we assume about inventories?

The price level is assumed to be constant along the aggregate expenditure line. Unplanned inventories are assumed to vary to signal to firms when they are overproducing or underproducing—inventories shrink when firms are underproducing and expand when firms are overproducing.

In your own words, explain the logic of the income-expenditure model. What determines the amount of real GDP demanded?

The quantity of real GDP demanded, given the price level, is found where aggregate expenditure equals real GDP - that is, where desired spending equals the amount produced. Real GDP can be viewed as both the value of aggregate output and as the aggregate income generated by that level of output. Because real GDP is measured on the horizontal axis and aggregate expenditure is measured on the vertical axis, the graph of the aggregate expenditure line drawn against a 45-degree line (representing points where real GDP and expenditure are equal) is referred to as the income-expenditure model.

(Real Wages) In Exhibit 2 in this chapter, how does the real wage rate at point c compare with the real wage rate at point a? How do nominal wage rates compare at those two points? Explain your answers.

The real wage at point c is exactly the same as at point a. The reason is simple. The output levels are the same; if there has been no change in labor supply or demand, the real wage must also be the same. Note that this is the equilibrium real wage and corresponds to potential output. There is no frictional unemployment associated at this real wage. The money wage at point a is higher than that at point c. The reason is that the rise in the expected price level pushes up the money wage, thus decreasing short-run aggregate supply. In fact, the short-run aggregate supply curve shifts to the left because the money wage increases.

In interpreting the short-run aggregate supply curve, what does the adjective short-run mean? Explain the role of labor contracts along the SRAS curve.

The short run is the period during which the prices of some resources, especially labor, are fixed by implicit or explicit contracts. Firms and those who supply resources have insufficient time to adjust to an unexpected change in the price level. Labor contracts may cause production costs to change more slowly than output prices. When output prices rise, for example, some wages are fixed by contract. Thus, firms' revenues would rise more rapidly than costs, and increasing production leads to greater profits. Actual price increases lead to increased real output—and therefore the aggregate supply curve slopes upward.

14. (Simple Spending Multiplier) Suppose that the MPC is 0.8 and that $17 trillion of real GDP is currently being demanded. The government wants to increase real GDP demanded to $18 trillion at the given price level. By how much would it have to increase government spending to achieve this goal?

The simple spending multiplier is 5. If government spending is increased by $200 million, real GDP demanded will increase by five times $200 million, or $1 trillion, bringing real GDP demanded to a total of $18 trillion.

12. (MPC and MPS) If consumption increases by $12 billion when disposable income increases by $15 billion, what is the value of the MPC? What is the relationship between the MPC and the MPS? If the MPC increases, what must happen to the MPS? How is the MPC related to the consumption function?

The value of the MPC is 12/15 = 0.80. Because disposable income can only be consumed or saved, the MPC and the MPS always add up to 1. Therefore, if the MPC rises, the MPS must fall. The MPC is the slope of the consumption function.

What does a recessionary gap imply about the actual rate of unemployment relative to the natural rate? What does it imply about the actual price level relative to the expected price level? What must happen to real and nominal wages in order to close a recessionary gap?

With a recessionary gap, unemployment exceeds the natural rate, and the actual price level is below the expected price level. To close the recessionary gap, the real wage must fall. This requires the nominal wage to fall or at least rise more slowly than output prices rise.

Consumption) Use the following data to answer the questions below: Real Disposable Consumption Income billions ($) Expenditures billions ($) Saving billions ($) $100 $150 ______ 200 200 ______ 300 250 ______ 400 300 ______

a. b. The slope is 1/2, equal to the marginal propensity to consume. c. The saving column should read −50, 0, 50, and 100, respectively.

Answer the following questions on the basis of the following graph: a. If the actual price level exceeds the expected price level reflected in long-term contracts, real GDP equals ________ and the actual price level equals ________ in the short run. b. The situation described in part (a) results in a(n) ________ gap equal to ________. c. If the actual price level is lower than the expected price level reflected in long-term contracts, real GDP equals ________ and the actual price level equals ________ in the short run. d. The situation described in part (c ) results in a(n) ________ gap equal to ________. e. If the actual price level equals the expected price level reflected in long-term contracts, real GDP equals ________ and the actual price level equals ________ in the short run. f. The situation described in part (e) results in ________ gap equal to ________.

a. $17.2 trillion; 130 b. expansionary; $0.2 trillion c. $16.7 trillion; 110 d. recessionary; $0.3 trillion e. $17.0 trillion; 120 f. no output gap; $0 trillion

Determine whether each of the following, other things held constant, would lead to an increase, a decrease, or no change in long-run aggregate supply: a. An improvement in technology b. A permanent decrease in the size of the capital stock c. An increase in the actual price level d. An increase in the expected price level e. A permanent increase in the size of the labor force

a. Increase b. Decrease c. No change d. No change e. Increase

How would an increase in each of the following affect the consumption function?

a. There is a downward movement along the consumption function as real disposable income falls. b. The consumption function shifts downward. c. The consumption function shifts upward. d. The consumption function shifts downward. e. The consumption function shifts upward. f. This generates an upward movement along the same consumption function.

) Complete each of the following sentences: a. The _________ wage measures the wage in dollars of the year in question, while the ________ wage measures it in constant dollars. b. Wage agreements are based on the ________ price level and negotiated in ________ terms. Real wages are then determined by the ________ price level. c. The higher the actual price level, the _________ is the real wage for a given nominal wage. d. If nominal wages are growing at 2 percent per year while the annual inflation rate is 3 percent, then real wages change by _________.

a. nominal; real b. expected; nominal; actual c. lower d. 1 percent