Download Chapter 25: Aggregate Demand, Aggregate Supply and Modern

Chapter 10: Aggregate Demand/ Aggregate Supply Model
Chapter 10: Aggregate Demand/ Aggregate Supply Model
Questions and Exercises
1.
The central difference between activist and laissez-faire economists is their
differing views about whether the economy is self-regulating. Laissez-faire
economists (Classicals) believe the pricing mechanism will bring the economy to
an equilibrium (potential output and full employment). Keynesians, on the other
hand, believe that the government sometimes needs to use fiscal policies (such as
changing tax levels and government spending) in order to keep the economy from
getting stuck above or below potential output and full employment.
2.
Classicals felt that if the wage level fell, the Depression would end. They saw
labor unions as preventing the fall in wages, and they believed that government
lacked the political will to break up unions.
3.
One expects the AD curve to be vertical because when the price level rises, all
prices rise together. That is, since wages have risen as much as prices for
consumer goods, no relative prices have changed and therefore people’s decisions
to consume should not change either.
4.
Five factors that shift the AD curve are: changes in foreign income, changes in
expectations, changes in exchange rates, changes in the distribution of income,
and changes in governmental aggregate demand policy.
5. a. A rise in the price level reduces the value of cash people hold. They withdraw
more from their banks to regain that value, which reduces the amount banks have
to lend. The interest rate rises, which reduces investment expenditures.
b. Assuming fixed exchange rates, a rise in the price level would make goods less
internationally competitive. This would lead to a decrease in net exports.
c. When there is a rise in the price level the holders of money become poorer so they
will buy less.
6. a. The AD curve will be steeper because a change in the price level will be offset by
a change in the exchange rate eliminating the international effect on the AD
curve.
b. The AD curve will become steeper if a fall in the price level doesn't make people
feel richer since the fall in the price will not cause them to increase their
expenditures. This is an example of the money wealth effect not holding true.
c. The AD curve will be steeper if a fall in the price level creates expectations of a
further fall in the price level (it may even be backward bending) since the fall in
the price level will cause people to reduce their present expenditures in the hope
of getting more for their money in the future.
d. Assuming that poor people spend a higher percentage of their income than rich
people (as suggested by the data), the AD curve will shift to the right.
e. The AD curve will shift to the right by a multiple of 20 (the multiplier effect).
Colander’s Economics, 8e. McGraw Hill © 2010
1
Chapter 10: Aggregate Demand/ Aggregate Supply Model
f. The AD curve will shift to the left by a multiple of 10 (the multiplier effect).
7.
A falling price level could reduce aggregate demand (shift the demand curve to
the left) by more than the lower price level increases the quantity of aggregate
demand because a lower price level brings with it expectations of falling
aggregate demand and lower asset prices.
8.
Two factors that shift the SAS curve are changes in productivity and changes in
input prices.
9. a. The SAS curve will shift up by 1 percent since wages rise by more than the rise in
productivity.
b. The SAS curve will shift down by 2 percent since productivity rises by more than
the rise in wages.
c. The SAS curve will shift up by 2 percent since wages rise and productivity
declines.
d. The SAS curve will not shift since the wage increase is exactly offset by a
productivity increase.
10.
The LAS curve is vertical because potential output depends on the capacity for
production, not the price level. In the long run, output is independent of the price
level.
11. a. An increase in the availability of inputs will shift the LAS curve to the right.
b. A civil war will presumably destroy productive capacity or otherwise halt
production and cause a shift in the LAS curve to the left. In the short run, it will
also increase the prices of inputs and increase inflationary expectations, shifting
the SAS up.
c. If wages that were fixed become flexible and aggregate demand increases, the
SAS curve will shift up as wages rise.
12.
If the economy is in short-run equilibrium below potential output, underutilization
of inputs will cause input prices to fall, causing the short-run aggregate supply
curve to shift down and the price level to fall. This will set the money wealth,
interest rate, and international effects in motion, increasing the quantity of
aggregate demand and thereby bringing the economy into long-run equilibrium at
potential output.
13. a. This implies that productivity is increasing significantly. If computers are a large
portion of the economy, and wages do not rise by the full amount of the
productivity increase, the result will be to lower the price level and increase
output.
b. In terms of the AS/AD model, this shifts the SAS curve down. It can also shift out
the potential output (LAS) curve to the right, increasing equilibrium potential
output and lowering the price level.
Colander’s Economics, 8e. McGraw Hill © 2010
2
Chapter 10: Aggregate Demand/ Aggregate Supply Model
14. a
It is likely that the rise in oil prices will shift the
SAS curve up and the drop in world income will
shift the AD curve in, causing equilibrium income
to fall even more below potential (from point A to
point B in the accompanying graph).
b. We might suggest expansionary fiscal and
monetary policy to shift the AD curve out (from
AD0 to AD2) and bring equilibrium income to its
potential. We would caution the government
about the possible inflationary consequences, but
since the economy is significantly below
potential, we would argue that it is a risk worth
taking.
15. a. The slowing of foreign economies will reduce exports, shifting the AD curve to
the left by a multiple of the initial decline in exports (from AD0 to AD1 in the
accompanying graph). I would recommend that the government increase
expenditures by an amount equal to the initial decline in exports. This will shift
the AD curve back to its initial position, as shown in graph (a) below.
b. An economy operating above potential output is shown by point A in graph (b).
To keep the inflation from rising (the SAS curve from shifting up), the
government should reduce expenditures enough (shifting the AD curve from AD0
to AD1) to bring the economy back to long-run equilibrium at potential output,
YP, and the price level, P1, as shown below.
c. A new technology that increases potential output will shift the LAS curve to the
right (from LAS0 to LAS1), as shown in graph (c) below, creating excess capacity
and downward pressure on factor prices. If left alone, the price level will fall and
real output will rise. If the government wants to keep the price level constant, or if
it wants to take advantage of a faster increase in aggregate demand, it can increase
expenditures enough to increase output to the new potential (shifting the AD
curve from AD0 to AD1).
Colander’s Economics, 8e. McGraw Hill © 2010
3
Chapter 10: Aggregate Demand/ Aggregate Supply Model
(a)
(b)
(c)
16.
When the price level falls, people may
expect aggregate demand to decline because
falling asset prices reduce people’s wealth.
In addition, falling asset prices might lead to
banks calling in loans, which will reduce
investment. Both of these shift the aggregate
demand curve to the left, offsetting the
effect of a falling price level on the quantity
of aggregate demand. This is shown in the
graph on the right. As the SAS curve begins
to shift from SAS0 to SAS1, the price level
falls and the economy begins to move
toward point B. But the aggregate demand
curve then shifts to the left from AD0 to AD1 as a result of the price level decline.
The economy then moves toward point C. Without government intervention this
cycle of falling prices and falling aggregate demand can continue indefinitely.
17.
Countercyclical fiscal policy is difficult to implement because it is difficult to
assess the condition of the economy at any one time. Furthermore, it takes a long
time to enact new government policies and it is politically difficult to raise taxes
when the economy is doing well (or at any time). Oftentimes politics, not the
needs of the economy, guide tax and spending decisions.
18.
To design an appropriate fiscal policy, it is important to know the level of
potential output because where the economy is relative to potential tells you
whether to implement expansionary or contractionary policy. Conducting fiscal
policy without having an estimate of potential output would be like driving
without being able to see the road.
Colander’s Economics, 8e. McGraw Hill © 2010
4
Chapter 10: Aggregate Demand/ Aggregate Supply Model
19.
As can be seen in the following diagram, a
large increase in potential output (shifting
the LAS curve to the right) would cause
downward pressure on the price level from
P0 to P1. As the price level shifts down the
output level increases from Y0 to Y1. This is
the argument some economists used to
suggest policy makers didn’t need to worry
about inflation.
20.
The simple model abstracts from a number of important issues such as the
problem of estimating potential income. Without knowing potential income, we
cannot know whether expansionary or contractionary policy is called for. Also,
dynamic price level adjustment feedback effects are ignored. Finally, the model
does not take into account the difficulties in implementing fiscal policies and the
uncertain effectiveness of those policies.
Issues to Ponder
1. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was
a Marshallian who saw economic models as an engine of analysis, not an end in
and of themselves.
b. It fits in nicely with the “other things constant” assumption since the policy
relevance of theory follows only when one has eliminated that assumption and
taken into account all the things held at the back of one’s mind.
c. It definitely was primarily in the art of economics since the above method is the
method used in the art of economics. Keynes was interested in using well thought
out theories and models to develop policies that would help society fulfill its
goals.
2.
Yes, they would emphasize the inherent value of the program rather than
discussing the program’s effect on aggregate demand. This is because programs
that increase aggregate demand when the economy is close to potential output will
ultimately lead to inflation and little increase in real output.
3.
My answer would not be affected in the sense that I would still suggest
expansionary fiscal policy. I might have to suggest slightly more expansionary
fiscal policy in order to offset the additional effect of the falling price level.
Colander’s Economics, 8e. McGraw Hill © 2010
5