Problem Set 4 Chapter 12/13 PDF

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Problem Set 4 Chapter 12

2. Your study partner is confused by the upward-sloping short-run aggregate

supply curve and the vertical long-run aggregate supply curve. How would you explain this?? Basically, the upward sloping short run aggregate supply curve will go upward due to nominal wages fixational behavior in the short run. Even if aggregate price falls the nominal wage will maintain itself the same. What will change though are the production costs causing a decrease in product/services output. If the aggregate price rises the contrary happens, production does not rise and again the nominal wage remains stabilized and this will cause output to increase. In the vertical long run aggregate supply curve, the nominal wage is affected by the changes in price level at the same stake, if one rises the other rises and if one falls the other also decreases. 4. The economy is at point A in the accompanying diagram. Suppose that the aggregate price level rises from P1 to P2. How will aggregate supply adjust in the short run and in the long run to the increase in the aggregate price level? Illustrate with a diagram. As for the short run, the aggregate price level will rise yet nominal wage will remain unchanged causing an increase in aggregate supply from Y1 to Y2. moving the whole economy from point A to B, increasing the real GDP. As for the long run, the aggregate price level rise will prompt a rise, bringing a leftward shift in the nominal wage upward. This then will bring about a leftward shift.

11.

Using aggregate demand, short-run aggregate supply, and long-run

aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the shortrun and long-run effects on the aggregate price level and aggregate output? a. There is a decrease in households’ wealth due to a decline in the stock market. A decrease in household wealth due to a decline in the stock market will bring down consumer spending, aggregate demand will then decrease and shift from AD1 to AD2. Since nominal wages are sticky, equilibrium will set itself at E2 yet aggregate price level will be lower than E1 as well as aggregate supply which will be below potential - this is a recessionary gap. Government intervention and negotiation can/will stabilize wages and supply bringing the curve to SRAS2, setting the new equilibrium will be set at a much lower aggregate price level at E3.

b) The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases. Consumer spending will increase right away shifting the aggregate demand curve to the right D1 to D2 as of equilibrium at E1 which from sticky wages in the short run shifts the curve to equilibrium at E2 - this is an inflationary gap. To be fixed with government intervention and negotiation, nominal wages will rise and the Demand curve will go leftward to SRAS2 meeting AD2 through E2 and at E3 stabilized at full potential output.

14. In the accompanying diagram, the economy is in long-run macroeconomic equilibrium at point E1 when an oil shock shifts the short-run aggregate supply curve to SRAS2. Based on the diagram, answer the following questions.

a. How do the aggregate price level and aggregate output change in the short run as a result of the oil shock? What is this phenomenon known as? This phenomenon is known as stagflation which combines unemployment and inflation, it shifts the supply curve leftward in the short run and increases price level to P2 and real GDP decreases to Y2. b. What fiscal or monetary policies can the government use to address the effects of the supply shock? Use a diagram that shows the effect of policies chosen to address the change in real GDP. Use another diagram to show the effect of policies chosen to address the change in the aggregate price level. Fiscal and monetary policies are able to increase real GDP, especially through increase in their spending and lower taxes to insure circulation of capital, this would raise the price level. The contrary could bring about a worse recessionary gap.

c. Why do supply shocks present a dilemma for government policy makers? Because fiscal and monetary policies will correct one issue at the consequence of worsening another. It cannot fix the whole economy. So in a way it is important to decide what is really important and what must be sacrificed. Chapter 12

2. The accompanying diagram shows the current macroeconomic situation for the economy of Brittania; real GDP is Y1, and the aggregate price level is P1. You have been hired as an economic consultant to help the economy move to potential output, YP.

a. Is Brittania facing a recessionary or inflationary gap? Brittania is facing an inflationary gap.

b. Which type of fiscal policy—expansionary or contractionary—would move the economy of Brittania to potential output, YP? What are some examples of such policies? Contractionary fiscal policy such as reducing government purchases of good and services, lowering government transfers and raising taxes.

c. Illustrate the macroeconomic situation in Brittania with a diagram after the successful fiscal policy has been implemented.

4. During a 2008 interview, then German Finance Minister Peer Steinbrueck said, “We have to watch out that in Europe and beyond, nothing like a combination of downward economic [growth] and high inflation rates emerges—something that experts call stagflation.” Such a situation can be depicted by the movement of the short-run aggregate supply curve from its original position, SRAS1, to its new position, SRAS2, with the new equilibrium point E2 in the accompanying figure. In this question, we try to understand why stagflation is particularly hard to fix using fiscal policy.

a. What would be the appropriate fiscal policy response to this situation if the primary concern of the government was to maintain economic growth? Illustrate the effect of the policy on the equilibrium point and the aggregate price level using the diagram. They can implement expansionary fiscal policy such as lowering taxes and increasing spending this way, shifting the aggregate demand curve to the right at setting equilibrium at Yp and price at P3.

b. What would be the appropriate fiscal policy response to this situation if the

primary concern of the government was to maintain price stability? Illustrate the effect of the policy on the equilibrium point and the aggregate price level using the diagram. They can implement contractionary fiscal policy such as raising taxes or lowering government spending, causing the aggregate demand curve to shift to the left increasing the recessionary gap yet stabilizing the price.

c. Discuss the effectiveness of the policies in parts a and b in fighting stagflation. Expansionary policies can help bring aggregate supply back to potential output, but also raises the price level worsening inflation. Contractionary policies bring down price level yet increase the inflationary gap. 6. In each of the following cases, either a recessionary or inflationary gap exists. Assume that the aggregate supply curve is horizontal, so that the change in real GDP arising from a shift of the aggregate demand curve equals the size of the shift of the curve. Calculate both the change in government purchases of goods and services and the change in government transfers necessary to close the gap. a. Real GDP equals $100 billion, potential output equals $160 billion, and the marginal propensity to consume is 0.75. This is the case of a recessionary gap since GDP is less than output. 1/(1-0.75)= 4 An increase in government purchases by 15 billion will increase GDP by 60 billion fixing the gap. MPC/(1-MPC)x$1 = 0.75/(1-0.75)x$1=$3. Real GDP needs 60 billion to reach full potential, for this government needs to increase

transfers by 20 billion to fix the gap. b. Real GDP equals $250 billion, potential output equals $200 billion, and the marginal propensity to consume is 0.5. The economy is facing an inflationary gap, real GDP is higher than output. 1/(1-0.5)=2 A decrease in government purchases by 25 billion will reduce GDP by 50 billion fixing the gap. MPC/(1-MPC)x$1 = 0.5/(1-0.5)x$1=$1. Real GDP needs to decrease 50 billion to stabilize at potential, for this government needs to decrease transfers by 50 billion to fix the gap. c. Real GDP equals $180 billion, potential output equals $100 billion, and the marginal propensity to consume is 0.8. The first economy is facing an inflationary gap. 1/(1-0.8)=5 A decrease in government purchases by 16 billion will reduce GDP by 80 billion fixing the gap. MPC/(1-MPC)x$1 = 0.8/(1-0.8)x$1=$4. Real GDP needs to decrease 80 billion to stabilize at potential, for this government needs to decrease transfers by 20 billion to fix the gap.

Additional problems 1. You

are

appointed

the

Supreme

Economic

Decider

for

the

nation of ILOVEMYCELLPHONE. The economy is currently at full employment (the potential level of output) and the price level is stable. However, recently

consumers

and businesses have become less confident in the

economy and decreased spending.

a) Using the diagram below representing the AD-AS model, explain verbally and diagrammatically both the short-run and long runeffects of this change in consumer spending assuming no policy is taken

to

address

the

issue.

Make sure you

label your graph

correctly and provide a precise but short explanation STEP BY STEP. In the short run, the fall on demand will cause the curve to shift leftward to d2 causing a slight decrease in the real GDP and a move to the left to E2. Since no policy is taken to fix this fall back, in the long run, the invisible hand will be at work, bringing the economy back to a stable point in E3.

b) Fearing a recession, the government asks you for your advice as to whether to undertake fiscal policy to offset this situation. Suppose you are convinced that fiscal policy is the appropriate action to take. Again, assume the economy was at full employment (the potential level of output) and the price level was stable consumer

and

representing

business the

sentiment.

AD-AS

model,

prior Using

to

the

change

the diagram

explain

verbally

in

below and

diagrammatically the short-run effect of the change in consumer and business sentiment and how fiscal policy could be implemented to offset the negative consequences of the change. Make sure you label

your graph correctly and provide a precise but short explanation STEP BY STEP. In the short run, the same as the question a) will take place. As soon as the consumers start buying leff the demand curve will shift leftward and down to D2, real GDP will decrease moving the equilibrium to E2, which through expansionary policies will be brought to stabilization at E3....