Download Solutions to PSET 4 1. Why does the AS curve slope up, at least in

Solutions to PSET 4
1. Why does the AS curve slope up, at least in the short run? Some argue that the AS
curve is always vertical. What is this argument?
The aggregate supply curve describes the relationship between the price level and the
total quantity of output produced by firms. Because firms have market power (as in
monopolistic competition) they may raise output and prices in response to an increase in
demand for their products. When aggregate demand rises, price level rises but wages tend
be sticky, moving only gradually in response to price level changes so that the marginal
cost curve does not shift up along with prices. Because price rises faster than marginal
costs, firms find it profitable to increase production. As a result, an increase in prices is
accompanied by an increase in firm output, that is, the aggregate supply curve slopes up,
at least in the short run.
This increase in output may be only temporary because nominal wages gradually adjust,
raising marginal costs and returning supply to a long-run level consistent with full
employment. Some economists who dismiss the idea of sticky wages believe that the AS
curve is always vertical, arguing that wages adjust proportionally as prices adjust.
Furthermore, there is likely to be an output level beyond which the economy no longer
has an excess capacity to produce so that any increase in aggregate demand will be met
with price increase (and proportional wage increase) rather than with output increase.
Hence, beyond this maximum output capacity level, the AS curve is likely to be vertical.
2. Why does the AD curve slope down? What role does the Fed rule play in this
derivation? What is the theory behind the Fed rule?
The aggregate demand curve describes the relationship between the price level and total
spending in the economy. It slopes down because the monetary policy authority responds
to changes in the price level by adjusting the interest rate according to a monetary policy
rule, which dictates that the Fed raise the interest rate when inflation is high and so the
price level is increasing, and lower the interest rate when inflation is low and so the price
level is decreasing (or not increasing as much). Because an increase in the interest rate
lowers planned investment (and a decrease raises it), the Fed response of raising the
interest rate in response to higher prices results in reduced investment spending, which in
turn lowers income and so also reduces consumption spending via the multiplier effect. In
this way, price level increases reduce aggregate spending and decreases increase it.
It is important to note that AD curve is not a market demand curve. This means that one
cannot simply employ the logic of substitution and income effects to explain the negative
slope of the AD curve. Unlike the market demand curve which plots quantity demanded
of a good for different possible prices holding prices of all other goods fixed, the AD
curve plots the economy’s aggregate output for different possible overall price levels,
which allows prices of different goods to vary simultaneously. Instead, as explained
above, the negative slope of AD curve must be explained using the Fed behavior and
investment function: when price level rises, Fed raises the interest rate, which then lowers
planned investment and hence aggregate output.
3. Why does an increase in oil prices shift the AS curve to the left? We are now seeing an
increase in oil prices. In the model so far (i.e., the AS/AD model) is an increase in oil
prices bad for the economy? Why or why not?
An increase in oil prices increases the marginal costs of many producers, who use oil as
an input to their production processes (either directly as in manufacturing, or indirectly
through costs of energy or transportation, which themselves use oil as an input). This
increase in marginal costs raises the price at which any level of output can be produced,
and so increases the price level that firms can profitably charge at any level of output.
Based on the AS/AD model learned in class so far, the increase in oil prices shifts AS
curve to the left, which results in lower output and a higher price level. This is bad for the
overall economy. Nonetheless, some sectors of the economy like the oil industry may
reap increased profits from now having to sell their products at a higher price. Moreover,
the stock prices of the oil companies are likely to increase, which may increase their
shareholders’ wealth and consumption depending on their investment portfolios.
4. Why does a decrease in G shift the IS curve to the left?
A decrease in G, government spending, lowers income directly and as a result, lowers
consumption spending, which further lowers income and spending because of the
multiplier in the economy. This results in a lower level of total spending for any given
interest rate, and so the IS curve, which describes the total quantity of spending at each
interest rate, shifts left.
5. Use the AS/AD model to explain how stagflation can occur.
Stagflation is a period of simultaneous inflation, or increase in the price level, and
stagnation or recession, or decline in total output. With a downward sloping aggregate
demand curve (as explained in 2.) and an upward sloping aggregate supply curve (as
explained in 1), an increase in prices and a decrease in output can occur via a movement
up and left along the aggregate demand curve, which can occur due to a shift up of the
aggregate supply curve. This may occur, for example, due to a sudden increase in oil
prices, which shifts up the aggregate supply curve, raising prices and thereby causing a
movement along the aggregate demand curve as the rise in prices leads the monetary
authority to raise interest rates and thereby contract spending.
6. What happens regarding the effects of fiscal policy and monetary policy in the AS/AD
model if planned investment (I) does not depend on the interest rate?
If planned investment (I) does not depend on the interest rate in the AS/AD model, this
means that (if the interest rate also does not have other effects), the IS curve which relates
interest rates and output, becomes vertical. If this is the case, shifts in monetary policy,
which move the Fed rule curve up or down, have no effect on output and only change the
interest rate. The aggregate demand curve becomes vertical and is no longer moved at all
by shifts in the interest rate, so monetary policy also has no effect on the price level.
Fiscal policy shifts the IS curve right or left (depending on whether it involves increasing
or decreasing government spending, or lowering or raising taxes, respectively). A shift
right in the IS curve moves along the Fed rule curve, resulting in a rise in interest rates,
but this rise in rates does not reduce investment and so the increase in spending is greater
than it would have been in the case that this change in interest rates reduced spending.
The AD curve shifts right in response to this expansionary fiscal policy, which results in
a move along the AS curve, resulting in an increase in the price level. Overall, this
change results in a larger response of output, a larger response of interest rates, and a
larger response of the price level to a given change in fiscal policy, while it leads to a
zero response of output and inflation and a larger response of interest rates to a change in
monetary policy.