Download 19e ch 35 insert C

Chapter 35 - Extending the Analysis of Aggregate Supply
Chapter 35 Extending the Analysis of Aggregate Supply
QUESTIONS
1. Distinguish between the short run and the long run as they relate to macroeconomics. Why is
the distinction important? LO1
Answer: For macroeconomists the short run is a period in which wages (and other input
prices) do not respond to price level changes. There are at least two reasons why nominal
wages may remain constant for a while even though the price level has changed.
1. Workers may not be aware of price level changes, and thus have not adjusted their
demands.
2. Many employees are hired under fixed wage contracts.
Once sufficient time has elapsed for contracts to expire and nominal wage adjustments to
occur, the economy enters the long run a period in which nominal wages are fully
responsive to changes in the price level.
The economy will adjust itself to a long-run equilibrium, but in the short run there may
be a positive role for stabilization (fiscal and monetary) policy.
2. Which of the following statements are true? Which are false? Explain why the false statements
are untrue. LO1
a.Short-run aggregate supply curves reflect an inverse relationship between the price level and the
level of real output.
b.The long-run aggregate supply curve assumes that nominal wages are fixed.
c.In the long run, an increase in the price level will result in an increase in nominal wages.
Answer:
(a) False, short run aggregate supply curves reflect a direct relationship between the
price level and the level of real output. If there is an increase in the price level, the
higher product prices bring an increase in revenue from sales to business firms.
Since the nominal wages they are paying are fixed, their profits rise. In response
firms collectively increase their output. Producers respond to a decrease in the price
level by cutting output. When product prices fall with nominal wages constant firms
will discover their revenue and profits have diminished.
(b) False, by definition, nominal wages in the long run are fully responsive to changes in
the price level.
(c) True, as above.
3. Suppose the full-employment level of real output (Q) for a hypothetical economy is $250 and
the price level (P) initially is 100. Use the short-run aggregate supply schedules below to answer
the questions that follow: LO1
35-1
Chapter 35 - Extending the Analysis of Aggregate Supply
a.What will be the level of real output in the short run if the price level unexpectedly rises from
100 to 125 because of an increase in aggregate demand? What if the price level unexpectedly falls
from 100 to 75 because of a decrease in aggregate demand? Explain each situation, using
numbers from the table.
b.What will be the level of real output in the long run when the price level rises from 100 to 125?
When it falls from 100 to 75? Explain each situation.
c. Show the circumstances described in parts a and b on graph paper, and derive the long-run
aggregate supply curve.
Answer:
(a) $280; $220. When the price level rises from 100 to 125 [in aggregate supply
schedule AS(P100)], producers experience higher prices for their products. Because
nominal wages are constant, profits rise and producers increase output to Q = $280.
When the price level decreases from 100 to 75, profits decline and producers adjust
their output to Q = $75. These are short-run responses to changes in the price level.
(b) $250; $250. In the long run a rise in the price-level to 125 leads to nominal wage
increases. The AS(P100) schedule changes to AS(P125) and Q returns to $250, now
at a price level of 125. In the long run a decrease in price level to 75 leads to lower
nominal wages, yielding aggregate supply schedule AS(P75). Equilibrium Q returns
to $250, now at a price level of 75.
(c) Graphically, the explanation is identical to Figure 35.1b. Short-run AS: P1 = 100;
P2 = 125; P3 = 75; and Q1 = $250; a2 = $280; and a3 = $220. Long-run aggregate
supply = Qf = $250 at each of the three price levels.
4. Use graphical analysis to show how each of the following would affect the economy first in
the short run and then in the long run. Assume that the United States is initially operating at its
full-employment level of output, that prices and wages are eventually flexible both upward and
downward, and that there is no counteracting fiscal or monetary policy. LO2
a.Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices
rocketing upward.
b.Construction spending on new homes rises dramatically, greatly increasing total U.S.
investment spending.
c.Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports.
Answer:
(a) See Figure 35.4 in the chapter, less AD2. Short run: The aggregate supply curve
shifts to the left, the price level rises, and real output declines. Long run: The
aggregate supply curve shifts back rightward (due to declining nominal wages), the
price level falls, and real output increases.
35-2
Chapter 35 - Extending the Analysis of Aggregate Supply
(b) See Figure 35.3. Short run: The aggregate demand curve shifts to the right, and both
the price level and real output increase. Long run: The aggregate supply curve shifts
to the left (due to higher nominal wages), the price level rises, and real output
declines.
(c) See Figure 35.5. Short run: The aggregate demand curve shifts to the left, both the
price level and real output decline. Long run: The aggregate supply curve shifts to
the right, the price level falls further, and real output increases.
5. Between 1990 and 2009, the U.S. price level rose by about 64 percent while real output
increased by about 62 percent. Use the aggregate demand–aggregate supply model to illustrate
these outcomes graphically. LO2
Answer: In the graph shown, both AD and AS expanded over the 1990-2009 period. P2
is 64% above P1 and GDP2 is 62% greater than GDP1. Other graphical illustrations are
possible.
6. Assume there is a particular short-run aggregate supply curve for an economy and the curve is
relevant for -several years. Use the AD-AS analysis to show graphically why higher rates of
inflation over this period would be associated with lower rates of unemployment, and vice versa.
What is this inverse relationship called? LO3
Answer: As aggregate demand increases given a particular short-run aggregate supply
curve, increases in real output are associated with increases in the price level. When real
output increases, the unemployment rate decreases. The Phillips Curve shown on the
right expresses the same relationship as the AD-AS model, but graphs as an inverse
relationship because unemployment is on the horizontal axis rather than real output.
35-3
Chapter 35 - Extending the Analysis of Aggregate Supply
7. Suppose the government misjudges the natural rate of unemployment to be much lower than it
actually is, and thus undertakes expansionary fiscal and monetary policies to try to achieve the
lower rate. Use the concept of the short-run Phillips Curve to explain why these policies might at
first succeed. Use the concept of the long-run Phillips Curve to explain the long-run outcome of
these policies. LO4
Answer: In the short-run there is probably a tradeoff between unemployment and
inflation. The government’s expansionary policy should reduce unemployment as
aggregate demand increases. However, the government has misjudged the natural rate
and will continue its expansionary policy beyond the point of the natural level of
unemployment. As aggregate demand continues to rise, prices begin to rise. In the longrun, workers demand higher wages to compensate for these higher prices. Aggregate
supply will decrease (shift leftward) toward the natural rate of unemployment.
In other words, any reduction of unemployment below the natural rate is only temporary
and involves a short-run rise in inflation. This, in turn, causes long-run costs to rise and a
decrease in aggregate supply. The end result should be an equilibrium at the natural rate
of unemployment and a higher price level than the beginning level. The long-run Phillips
curve is thus a vertical line connecting the price levels possible at the natural rate of
unemployment found on the horizontal axis. (See Figure 35.11)
8. What do the distinctions between short-run aggregate supply and long-run aggregate supply
have in common with the distinction between the short-run Phillips Curve and the long-run
Phillips Curve? Explain. LO4
Answer: In the short-run, economists assume that production costs don’t change so the
aggregate supply curve is fixed. Therefore, changes in aggregate demand are the sole
determinant of unemployment and inflation rates. (Figure 35.1a) In the long-run, wages
and input prices adjust to price changes causing a rise (or fall) in production costs and
aggregate supply decreases (or increases) as shown in Figure 35.1b. This means the
long-run relationship between price-level and output is vertical at the full-employment
level of output.
35-4
Chapter 35 - Extending the Analysis of Aggregate Supply
The long-run Phillips curve illustrates this latter point with the natural rate of
unemployment (sometimes called full-employment rate) being measured on the
horizontal axis and price level on the vertical axis. The long-run curve is vertical as
shown in Figure 35.11. However, the short-run Phillips curve reflects what happens with
unemployment at different price levels using the short-run aggregate supply curve. (See
Figures 35.8 and 35.9.)
9. What is the Laffer Curve, and how does it relate to supply-side economics? Why is
determining the economy’s location on the curve so important in assessing tax policy? LO5
Answer: Economist Arthur Laffer observed that tax revenues would obviously be zero
when the tax rate was either at 0% or 100%. In between these two extremes would have
to be an optimal rate where aggregate output and income produced the maximum tax
revenues. This idea is presented as the Laffer Curve shown in Figure 35.12.
The difficult decision involves the analysis to determine what is the optimum tax rate for
producing maximum tax revenue and the related maximum economic output level.
Laffer argued that low tax rates would actually increase revenues because low rates
improved productivity, saving and investment incentives. The expansion in output and
employment and thus, revenue, would more than compensate for the lower rates.
10. Why might one person work more, earn more, and pay more income tax when his or her tax
rate is cut, while another person will work less, earn less, and pay less income tax under the same
circumstance? LO5
Answer: Proponents of supply-side economics argue that cuts in the marginal tax rate on
earned income will make work more attractive because the opportunity cost of leisure is
higher. Thus, individuals choose to substitute work for leisure. Critics of supply-side
reasoning contend that workers are just as likely to reduce their efforts because the aftertax pay increases their ability to “buy leisure.” They can meet their after-tax income
goals by working fewer hours.
11. LAST WORD On average, does an increase in taxes raise or lower real GDP? If taxes as a
percent of GDP go up 1 percent, by how much does real GDP change? Are the decreases in real
GDP caused by tax increases temporary or permanent? Does the intention of a tax increase
matter?
Answer: C. Romer and D. Romer show that tax increases reduce real GDP. On average
a 1 percent tax increase (as percentage of real GDP) reduces real GDP by 2 to 3 percent.
It appears that the intent of the tax increase matters. If the tax increase is to reduce the
deficit this tends to have a less negative effect on economic activity.
35-5
Chapter 35 - Extending the Analysis of Aggregate Supply
PROBLEMS
1. Use the accompanying figure to answer the follow questions. Assume that the economy
initially is operating at price level 120 and real output level $870. This output level is the
economy’s potential (or full-employment) level of output. Next, suppose that the price level rises
from 120 to 130. By how much will real output increase in the short run? In the long-run?
Instead, now assume that the price level dropped from 120 to 110. Assuming flexible product and
resource prices, by how much will real output fall in the short run? In the long run? What is the
long-run level of output at each of the three price levels shown?
LO1
Answers: $20; zero; $20; zero; $870.
Feedback: Consider the following example. Use the accompanying figure to answer the
follow questions. Assume that the economy initially is operating at price level 120 and
real output level $870. This output level is the economy’s potential (or full-employment)
level of output. Next, suppose that the price level rises from 120 to 130. By how much
will real output increase in the short run? In the long-run? Instead, now assume that the
price level dropped from 120 to 110. Assuming flexible product and resource prices, by
how much will real output fall in the short run? In the long run? What is the long-run
level of output at each of the three price levels shown?
35-6
Chapter 35 - Extending the Analysis of Aggregate Supply
AS3
Price Level
AS2
130
AS1
120
110
$850
$870
$890
output (dollars)
The economy is initially operating at the price level 120 and real output level $870 (on
AS2). This output level is also the economy’s potential (or full-employment) level of
output.
Next, suppose that the price level rises from 120 to 130. By how much will real output
increase in the short run? In the long-run?
In the short run aggregate supply will increase to $890, which is an increase of $20. The
short run is represented by movement along AS2.
In the long run the aggregate supply schedule will shift upward from AS2 to AS3 as
wages adjust. This moves the economy back to the potential (or full-employment) level
of output $870 at the price level 130.
Instead, now assume that the price level dropped from 120 to 110. Assuming flexible
product and resource prices, by how much will real output fall in the short run? In the
long run?
In the short run aggregate supply will fall to $850, which is a decrease of $20. The short
run is represented by movement along AS2.
In the long run the aggregate supply schedule will shift downward from AS2 to AS1 as
wages adjust. This moves the economy back to the potential (or full-employment) level
of output $870 at the price level 110.
What is the long-run level of output at each of the three price levels shown?
Given the answers above, the long-run level of output is $870 at each of the three price
levels.
35-7
Chapter 35 - Extending the Analysis of Aggregate Supply
2. ADVANCED ANALYSIS Suppose that the equation for a particular short-run AS curve is P
= 20 + .5Q, where P is the price level and Q is real output in dollar terms. What is Q if the price
level is 120? Suppose that the Q in your answer is the full-employment level of output. By how
much will Q increase in the short run if the price level unexpectedly rises from 120 to 132? By
how much will Q increase in the long-run due to the price level increase? LO1
Answers: $200; $24; zero.
Feedback: Consider the following example. Suppose that the equation for a particular
short-run AS curve is P = 20 + .5Q, where P is the price level and Q is real output in
dollar terms. What is Q if the price level is 120? Suppose that the Q in your answer is the
full-employment level of output. By how much will Q increase in the short run if the
price level unexpectedly rises from 120 to 132? By how much will Q increase in the
long-run due to the price level increase?
Since we are given the price level we need to solve the short-run AS curve for Q as a
function of P.
P = 20 + .5Q or Q = (P - 20) / 0.5
What is Q if the price level is 120?
Q = (120 -20) / 0.5 = 100/0.5 = 200
Assume this answer is the full-employment level of output.
By how much will Q increase in the short run if the price level unexpectedly rises from
120 to 132?
First, find Q for 132.
Q = (132 - 20) / 0.5 = 112/0.5 = 224
The change in Q is 24.
By how much will Q increase in the long-run due to the price level increase?
Q will return to the full-employment level of output defined above, Q = 200. Thus, the
long-run change is zero.
3. Suppose that over a 30-year period Buskerville’s price level increased from 72 to 138 while its
real GDP rose from $1.2 trillion to $2.1 trillion. Did economic growth occur in Buskerville? If so,
by what average yearly rate? Did Buskerville experience inflation? If so, by what average yearly
rate? Which shifted rightward faster in Buskerville: its long-run aggregate supply curve (ASLR)
or its aggregate demand curve (AD)? LO2
35-8
Chapter 35 - Extending the Analysis of Aggregate Supply
Answers: 2.50 percent; 3.06 percent; AD (or else the price level would not have increased!)
Feedback: Consider the following example. Suppose that over a 30-year period
Buskerville’s price level increased from 72 to 138 while its real GDP rose from $1.2
trillion to $2.1 trillion. Did economic growth occur in Buskerville? If so, by what average
yearly rate? Did Buskerville experience inflation? If so, by what average yearly rate?
Which shifted rightward faster in Buskerville: its long-run aggregate supply curve
(ASLR) or its aggregate demand curve (AD)?
Did economic growth occur in Buskerville?
Yes, real GDO rose over this time period.
If so, by what average yearly rate?
First, find the rate of growth for the given period of time (30 year period in this example).
Growth = (2.1 - 1.2)/1.2 = .9/1.2 = 0.75 in percentage form 75% (= 100 x 0.75)
To find the average annual rate of growth divide by the number of years in the period.
Growth annual = growth/30 = 2.50% (percentage form)
Did Buskerville experience inflation?
Yes, the price level rose over this period.
If so, by what average yearly rate?
First, find the inflation rate for the given period of time (30 year period in this example).
Inflation = (138 - 72)/72 = 66/72 = 0.9167 in percentage form 91.67% (= 100 x 0.9167)
To find the average inflation rate divide by the number of years in the period.
Inflation annual = inflation/30 = 3.06% (percentage form).
Which shifted rightward faster in Buskerville: its long-run aggregate supply curve
(ASLR) or its aggregate demand curve (AD)?
The AD schedule because the price level increased over this period of time.
4. Suppose that for years East Confetti’s short-run Phillips Curve was such that each 1 percentage
point increase in its unemployment rate was associated with a 2 percentage point decline in its
inflation rate. Then, during several recent years the short run pattern changed such that its
inflation rate rose by 3 percentage points for every 1 percentage point drop in its unemployment
rate. Graphically, did East Confetti’s Phillips Curve shift upward or did it shift downward? LO3
Answer: Upward.
35-9
Chapter 35 - Extending the Analysis of Aggregate Supply
Feedback: Consider the following example. Suppose that for years East Confetti’s shortrun Phillips Curve was such that each 1 percentage point increase in its unemployment
rate was associated with a 2 percentage point decline in its inflation rate. Then, during
several recent years the short run pattern changed such that its inflation rate rose by 3
percentage points for every 1 percentage point drop in its unemployment rate.
Graphically, did East Confetti’s Phillips Curve shift upward or did it shift downward?
The answer is upward.
The logic is as follows. The trade-off between inflation and unemployment is 2
percentage points for 1 percentage point (any change in unemployment by 1 percentage
point results in an opposite movement of inflation by 2 percentage points).
The new trade-off between inflation and unemployment is 3 percentage points for 1
percentage point (any change in unemployment by 1 percentage point results in an
opposite movement of inflation by 3 percentage points).
This results in an upward shift in the Phillips Curve.
Heuristically, we can think about it this way. Assume that at an unemployment rate of 4%
the inflation rate is zero. As we move to 3% unemployment the inflation rate increases to
2% given the original trade-off.
Now, with the new trade-off, as we move to 3% unemployment the inflation rate
increases to 3%. Thus, the new Phillips Curve must lie above the original (3% inflation
rate versus the 2% inflation rate at the unemployment rate of 3%).
35-10