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Ragan/Lipsey 11th (Chapter 24)
Question 5
a) In Economy A, the short-run equilibrium level of real GDP is greater than potential
GDP, Y*. The only way firms can produce more than Y* is to work their factors of
production more intensively. Workers work longer shifts or overtime. Capital is used for
longer periods before being maintained. Land is used more intensively. This means that
factor markets are in excess demand, and this excess demand puts upward pressure on
factor prices. As factor prices rise, firms’ unit costs start to increase.
b) As firms’ unit costs start to rise in Economy A, the AS curve starts to shift upward and
to the left. This shift indicates that firms are only prepared to supply the same level of
output at higher prices (to offset their higher costs). As the AS curve shifts up, the
equilibrium level of GDP falls and the equilibrium price level rises. This process
continues until Y = Y*, at which point factor markets are clearing and factor prices stop
rising.
c) In Economy B, the short-run equilibrium level of real GDP is less than potential GDP,
Y*. Firms produce less than Y* by working their factors of production less intensively
than normal. Workers are laid off or work short shifts. Some capital equipment is idle.
Some land is unused. This means that factor markets are in excess supply, and this excess
supply puts downward pressure on factor prices. As factor prices fall, firms’ unit costs
start to decrease.
d) As firms’ unit costs start to fall in Economy B, the AS curve starts to shift downward
and to the right. This shift indicates that firms are prepared to supply the same level of
output at lower prices (because their costs have fallen). As the AS curve shifts down, the
equilibrium level of GDP rises and the equilibrium price level falls. This process
continues until Y = Y*, at which point factor markets are clearing and factor prices stop
falling.
Question 8
a) See the figure below. The diagram shows the equilibrium at Y* and P0, as determined
by the curves AD0 and AS0. This economy is in long-run equilibrium because Y = Y* and
thus there is no pressure on factor prices to either rise or fall.
b) The reduction in the world price of raw materials (iron ore) is a positive supply shock.
The reduction in the price of iron ore reduces unit costs for firms that use iron ore as an
input. The AS curve shifts to the right to AS1. Real GDP rises to Y1 and the price level
falls to P1.
c) At Y1, there is an inflationary output gap. Factors of production are used more
intensively than normal, and so there is excess demand for factors. This excess demand
forces factor prices to rise, thereby increasing firms’ costs and shifting the AS curve
upward and to the left, reversing the initial shift. The AS curve eventually shifts back to
AS0, where output has returned to Y* and the price level has returned to P0. (Note,
however, that the rise in wages means that real wages are higher in the new long-run
equilibrium than was the case in the initial long-run equilibrium.)
d) If factor prices respond quickly to the inflationary gap, then output will return
relatively quickly to Y*. In this case there is not a strong case for a fiscal contraction. If
factor prices are slow in responding, there is more of a role for fiscal policy.