Chapter 8 Macroeconomics

What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model?

A smaller labor force would be reflected in a leftward shift in both short run aggregate supply and potential GDP. That would lead to a lower equilibrium level of GDP and a higher price level.

The foreign price effect (AD curve)

All else equal, as the domestic price level rises, our exports become more expensive to foreigners, and imports from other countries become relatively cheaper to us.

The Wealth Effect (AD curve)

All else equal, as the price level rises, the value of money falls. People who have money in any form become less wealthy, and so buy less, which means consumption falls.

What is the economic reason why the SRAS curve slopes up?

All else the same (especially resource prices), it becomes more profitable to produce as the price level rises. The price level reflects the prices of final goods and services.

How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?

An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending. That would shift the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level.

factors that could cause AD to shift, and say whether they would shift AD to the right or to the left.

Anything that causes consumption, investment, government purchases, or net exports to rise (EXCEPT if caused by a fall in the price level) will shift the AD curve to the right. Examples include improvements in business or consumer confidence, lower interest rates, lower taxes, more government purchases, and more prosperous trading partners.

Interest Rate Effect (AD curve)

As the price level rises, it requires more money to buy things. That raises the demand for money and credit, which increases the rate of interest. Higher interest rates mean less investment and consumption spending.

In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?

Equilibrium occurs at the level of GDP where AD = AS. Insufficient aggregate demand could explain why the equilibrium occurs at a level of GDP less than potential. A decrease (or leftward shift) in aggregate supply could be another reason.

What are some of the ways in which exports and imports can affect the AD/AS model?

Exports and imports directly affect the AD curve. An increase in net exports (exports minus imports) will shift the AD curve to the right, and a decrease in net exports will shift it to the left. In addition, if we are net importers of a key resource (such as oil), an increase in the world price of the resource will shift the SRAS curve to the left; a decrease in the world price will shift SRAS to the right.

Many financial analysts and economists eagerly await the press releases for the reports on the home price index and consumer confidence index. What would be the effects of a negative report on both of these? What about a positive report?

For most Americans, their house is a major portion of their wealth. If house prices decline, consumers will feel less wealthy and so reduce consumption spending. A negative report on consumer confidence would mean that consumers are more pessimistic about the future. They may therefore save more and consume less. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level.

Suppose concerns about the size of the federal budget deficit cause the U.S. Congress to cut all funding for research and development for ten years. Assuming this has an impact on technology growth, what does the AD/AS model predict would be the likely effect on equilibrium GDP and the price level?

Given the assumptions made here, the cuts in R&D funding should reduce productivity growth. The SRAS curve would shift to the right at a slower pace, which means that GDP will grow slower.

Suppose, after five years of sluggish growth, the economy of the European Union picks up speed. What would be the likely impact on the U.S. trade balance, GDP, and employment?

Higher EU growth would increase demand for U.S. exports, reducing our trade deficit. The increased demand for exports would show up as a rightward shift in AD, causing GDP to rise (and the price level to rise as well). Higher GDP would require more jobs to fill, so U.S. employment would also rise.

The short-run aggregate supply curve was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?

Higher input prices make output less profitable, decreasing the desired supply. This is shown graphically as a leftward shift in the AS curve.

Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.

If Mexico goes into recession, its GDP declines. With less income, it will import less. A fall in Mexican imports means a fall in U.S. exports. The decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level.

Suppose the U.S. Congress passes significant immigration reform that makes it easier for foreigners to come to the United States to work. Use the AD/AS model to explain how this would affect the equilibrium level of GDP and the price level.

Immigration reform as described would increase the labor supply which would reduce wages and shift SRAS to the right. That would lead to a higher equilibrium GDP and a lower price level. It would also increase potential GDP.

factors that could cause the SRAS curve to shift, and say whether they would shift SRAS to the right or to the left

Improvements in productivity will shift the SRAS curve to the right. Increases in input prices will shift the SRAS curve to the left; decreases in input prices will shift it to the right. Exceptionally bad weather will shift the SRAS to the left; exceptionally good weather will shift it to the right.

How is long-term growth illustrated in an AD/AS model?

Long-term growth is illustrated by a rightward shift of the LRAS curve, i.e., an increase in potential GDP. That is accompanied by a drift of the SRAS curve to the right.

What is potential GDP?

Potential GDP is the highest sustainable level of real GDP that an economy can produce. It is the level of real GDP where we fully employ labor, physical capital, and technology, given the existing market and legal institutions. For short periods of time the economy can produce more than potential GDP (think about every worker working twice as many hours), but we cannot produce beyond potential GDP for long

What is stagflation?

Stagflation occurs when the SRAS curve shifts left. The result is rising prices and falling real GDP.

A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?

Tax cuts increase consumer and/or investment spending, depending on where the tax cuts are targeted. This would shift AD to the right, so if the tax cuts occurred when the economy was in recession, the tax cuts could increase GDP and "lead the economy out of recession."

What are the components of the aggregate demand (AD) curve?

The components of aggregate demand are consumption, (intended) investment, government purchases, and net export spending. In symbols, aggregate demand = C + I + G + X - M.

How is the natural rate of unemployment illustrated in an AD/AS model?

The natural rate of unemployment is represented by the position of the LRAS curve. It shows us what real GDP would be if there were zero cyclical unemployment.

Suppose businesses became optimistic about the future state of the economy. What impact would that have on GDP, unemployment, and prices?

The optimism would likely lead to an increase in investment which would shift AD to the right. That would increase GDP, reduce unemployment, and increase prices.

What are the economic reasons why the AD curve slopes down?

There are three reasons why the AD curve has a negative slope: 1. The wealth effect. 2. The interest rate effect. 3. The foreign price effect. As a result, exports fall and imports rise. All of these effects are rather weak, so the AD curve is quite steep.

suppose structural unemployment rate rises, what happens to the LRAS

moves to the left

labor productivity changes

technological changes capital deepening

What is potential GDP?

the level of GDP when the rate of cyclical employment is zero. The only unemployment is frictional and structural