Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Economics 161 E. McDevitt SQ on the AS/AD model 1. What is the definition of aggregate demand? What are the components of aggregate demand? 2. What relationship is expressed by the aggregate-demand curve? Draw a graph of the AD curve. 3. Why does the aggregate demand curve have a negative slope? Be specific. 4. What are the shift variables for the aggregate-demand curve? Be sure to explain which component of AD is affected by this variable. 5. What is aggregate supply? 6. Why is the long-run aggregate-supply curve vertical? What factors shift the long-run aggregate-supply curve? Using a graph with the AD curve and LRAS curve, determine the impact on P and Y in the long run of the following events: there is an increase in the level of physical and human capital AND at the same time the money supply increased. If it is observed that P has risen, what does that imply about the relative shifts in each curve? 7. Why does the short-run aggregate-supply curve slope upwards? What is the significance of an upwardslopping short-run aggregate-supply curve? What factors shift the short-run aggregate-supply curve? 8. Use the following equation to answer the questions below: Quantity of output supplied (Y) = Natural Rate of Output + a(Actual P - Expected P) Assume that the natural rate of output is 2000 and that a=1. Assuming that Expected P = 100, fill in the rest of Table 1. Assuming that Expected P equals 80 fill in the rest of Table 2 Table 1 (Expected P=100) Actual P Y . 120 100 80 Table 2 (Expected P = 80) Actual P Y . 100 80 60 Draw in the short-run aggregate-supply (SRAS) curve corresponding to Table 1. Draw in the SRAS curve corresponding to Table 2. What conclusion do you draw about how the expected price level affects the SRAS curve? 9. Using graphs of the aggregate demand-aggregate supply model, answer each question below. Discuss the short-run effects. a. Suppose there is an unexpected drop in the money supply. b. Assume that consumer wealth unexpectedly rises. c. Assume that there is a perfectly anticipated increase in G. d. New and costly government regulations are imposed on producers. The regulations are temporary. e. A sudden but temporary drop in oil prices. 10. Multiple choice questions. Select the best answer. 10a. The mid-1970s experienced a sharp rise in the price level and a decline in real output. Which of the following events can best explain this outcome? a. A drop in consumer confidence that causes a decrease in the AD curve. b. An oil cutoff that results in a decrease in the SRAS curve. c. An increase in the money supply that causes an increase in the AD curve. d. The government temporarily removes burdensome regulations that cause an increase in the SRAS. 10b. The aggregate demand curve shows: a. the quantity of goods and services that households, firms, and the government want to buy at each price level. b. the quantity of goods and services that households, firms, and the government want to buy at each interest rate. c. the quantity of goods and services that households want to buy at each price level. d. The quantity of goods and services that firms want to buy at each interest rate. e. none of the above. 10c. The aggregate supply-aggregate demand model predicts that the short-run effects of a temporary but severe oil-cutoff would be: a. A decrease in the price level and an increase in real output. b. An increase in both the price level and real output. c. An increase in the price level and a decrease in real output. d. A decrease in both the price level and real output. 10d. Which of the following is NOT one of the components of aggregate demand? a. Consumption spending. b. Investment spending. c. Government spending on goods and services. d. Money supply. e. Net Exports. 10e. All of the following events would cause a rightward shift in aggregate-demand EXCEPT: a. A boom in the stock market that raises consumer wealth. b. An investment tax credit that raises the rate of return on investment. c. A recession abroad which decreases net exports. d. The Fed increases the money supply. e. An increase in government spending. 10f. Which of following help explain the negative slope of the aggregate demand curve? a. A lower price level increases real wealth, which encourages spending on consumption. b. A lower price level reduces the interest rate, which encourages spending on investment. c. A lower price level causes the real exchange rate to depreciate, which encourages spending on net exports. d. All of the above. e. None of the above. 10g. According to the Sticky-Wage Theory an unexpected decrease in the price level will cause: a. b. c. d. the nominal wage rate to fall by a proportional amount leaving the real wage rate, employment and real output unchanged. The real wage rate to fall, and employment and real output to rise. The real wage rate to rise, and employment and real output to fall. The nominal and real wage rate to fall, and employment and real output to rise. 10h. According to the Sticky-Price Theory: a. b. c. d. prices of some goods and services adjust slowly over time. menu costs make it costly for some sellers to immediately adjust price when economic conditions change. the short-run aggregate supply curve has a positive slope. all of the above. 10i. The aggregate supply-aggregate demand model predicts that the short-run effects of an unanticipated decrease in the expected future profitability of investment projects are: a. A decrease in the price level and an increase in real output. b. An increase in both the price level and real output. c. An increase in the price level and a decrease in real output. d. A decrease in both the price level and real output. ANSWERS 1. Aggregate demand refers to quantity of goods and services that households, firms, and the government want to buy at each price level. Aggregate demand consists of real consumption spending (C) , real investment spending (I), real government spending on goods and services, and net exports (NX). 2. The aggregate-demand curve shows the relationship between the quantity of goods and services that households, firms, and the government want to buy and the price level, as in the graph below. Price Level P1 P2 Aggregate Demand Y1 Y2 Quantity of Real Output 3. There are three reasons for this negative slope. a. Wealth Effect: Note that the nominal value of money is fixed (“ it takes one dollar to buy one dollar”). It therefore follows that a fall in the price level increases the purchasing power of a given amount of dollars. This makes consumers feel more wealthy, which in turn encourages consumers to spend more. The increase in the spending means a larger quantity of goods and services demanded. In summary: P purchasing power of money consumers feel more wealthy C AD. b. Interest-Rate Effect: A decrease in the price level causes a decrease in the demand for money. The public will therefore attempt to reduce their money holdings by purchasing other assets. For example, the public will convert some of their money into interest-bearing assets, which will lead to a drop in the interest rate (r) . Lower interest rates, in turn, stimulate borrowing by firms that want to invest in new capital goods. The increase in investment spending causes aggregate demand to rise. To summarize: P Money Demand Public attempts to reduce their money holdings by purchasing interest-bearing assets r I AD. c. Exchange-Rate Effect: This effect will discussed in more detailed in a later lecture. For now, let it suffice to say that P E NXAD. 4. Shift variables for AD curve: a. Shifts from Consumption—Any event that changes how much people want to consume at a given price level shifts the aggregate-demand curve. Changes in expected-future income (“consumer confidence”), wealth, and taxes would all affect current consumption spending. For example, suppose new information leads consumers to expect that their future income will fall (“drop in consumer confidence”). The resulting drop in consumption spending will cause the aggregate-demand curve to shift to the left. On the other hand, an increase in consumer confidence will cause the aggregate demand curve to shift to the right. As another example, suppose that a stock market boom makes people feel wealthier such that consumption spending rises. This would shift the aggregate demand to the right. As a final example, suppose the government cuts taxes. This encourages spending which increases aggregate demand. To summarize: changes in Wealth, Expected-Future Income, and Taxes would all shift the AD curve. b. Shifts from Investment— Any event that changes how much firms want to invest at a given price level shifts the aggregate-demand curve. For example, changes in firms’ expectations about future cash flows from investment projects (EFPI), changes in the tax rate on capital, and changes in the money supply which lead to short-run changes in the interest rate will all have an impact on current investment spending. Thus, an increase in business confidence will encourage investment spending. This causes the aggregate demand curve to shift to the right. Likewise, a reduction in the tax rate on capital will also encourage investment spending. As a final example, consider the impact of an increase in the money supply. As explained elsewhere, this will lower the interest rate in the short run. The lower interest rate will stimulate investment spending, thereby shifting out the aggregate-demand curve. To summarize: changes in EFPI, government policies that affect the incentive to invest, and the money supply would all shift the AD curve. c. Shifts from government spending on goods and services. Changes in government spending on goods and services will also shift the aggregate-demand curve. For example, an increase in federal spending on national defense will lead to a rightward shift in the aggregate-demand curve. Changes in spending by other levels of government would also shift the aggregate demand curve. d. Shifts arising from net exports. Any event that changes net exports for a given price level also shifts the aggregate-demand curve. For example, a recession abroad would tend to lower the demand for domestic goods, so net exports would fall. The fall in net exports would result in a leftward in the aggregate-demand curve. A change in the exchange rate, E, (for reasons other than that given above in our discussion of the Exchange-Rate Effect) would also cause a change in net exports. If the dollar appreciates, domestic goods become more expensive abroad and this would depress net exports. The drop in net exports would shift the aggregate demand curve to the left. To summarize: changes in E and Other factors that affect NX would shift the AD curve. Summary of AD shift variables Shift variables Wealth Component of AD affected C Impact on AD wealth C AD shifts rightwards wealth C AD shifts leftwards Expected –Future Income (“consumer confidence”) C ExFutInC AD shifts rightwards ExFutInC AD shifts leftwards Taxes C Taxes C AD shifts leftwards Taxes C AD shifts rightwards EFPI (“business confidence”) I EFPI I AD shifts rightwards EFPI I AD shifts leftwards Gov. Policies that encourage/discourage investment I (example: decrease/increase in tax rate on investment) . GovPolEncourageInv I AD shifts to right GovPolDiscourInv I AD shifts to the left Money Supply I MSshort-run r IAD shifts to the right MSshort-run rIAD shifts to the left G G G AD shifts to the right GAD shifts to the left Exchange rate NX ENXAD shifts to the right ENXAD shifts to the left Other factors that affect exports/imports (other than P) NX Factors that increase exports/decrease imports will increase NX and AD Factors that decrease exports/increase imports will decrease NX and AD. Using our summary notation we can write: AD=C(wealth, expected-future income, taxes)+I(EFPI, government policies…, MS)+G+NX(E, other). 5. Aggregate supply is the quantity of goods and services that firms choose to produce and sell at each price level. 6. In the long run, an economy’s production of goods and services (real output) depends on its supply of labor (Ls), capital(K), human capital (H) and natural resources (N) and on the available technology (A)used to turn these inputs into goods and services. Because the price level does not affect these underlying determinants of real output, the long-run aggregate supply curve is vertical, as in Figure 1. This level of output is known as the natural rate of output (Y LR in Figure 1). Price Level Figure 1. LRAS P1 P2 YLR Quantity of Real Output Shift variables for the LRAS curve: a. Shifts Arising from Labor— Changes in the working-age population or changes in the labor-force participation rate would change the number of workers in the economy and would therefore change aggregate supply. For example, a sudden wave of immigration would lead to a rightward shift in the longrun aggregate supply curve. The long-run aggregate-supply curve also depends on the natural rate of unemployment. For instance, if the government was to increase the minimum wage this would raise the natural rate of unemployment and reduce output—a leftward shift in the long-run aggregate-supply curve. A change in labor laws that reduce labor mobility would have the same impact on this curve. b. Shifts Arising from Capital—An increase in the economy’s capital stock allows an economy to produce more goods and services and therefore shifts the long-run aggregate supply curve to the right. On the other hand, a reduction in a country’s capital stock, due perhaps to war or some natural disaster, would shift the long-run aggregate-supply curve to the left. c. Shifts Arising from Human Capital--Likewise for human capital. An increase in human capital, due perhaps to a general increase in the level of education or to a general increase in the level of health, would shift the long-run aggregate-supply to the right. d. Shifts Arising from Natural Resources—An economy’s level of production also depends on its natural resources, including its minerals, land, weather. For example, the opening of land for settlement in the 19th century in the U.S. West led to a rightward shift in the long-run aggregate-supply curve. A sustained severe drought would shift the long-run aggregate-supply curve to the left. A prolonged cutoff of oil to a country that imports a significant amount oil would shift this curve to the left. e. Shifts Arising Technological Knowledge—Advances in our technological knowledge alter the amount of goods and services an economy can produce from a given set on inputs. The invention of the computer, for example, has increased input productivity and has thus lead to a rightward shift in the long-run aggregate-supply curve. The adoption of the assembly-line technique in certain industries has had a similar impact. There are other events that act like changes in technology. For example, a free-trade agreement that open up international trade, or the adoption of new forms of business organization, would shift the long-run aggregate-supply curve to the right. Government regulations preventing the use of certain techniques, perhaps because of environmental issues or worker-safety concerns, would result in a leftward shift. To summarize: Ls LRAS shifts to the right Ls LRAS shifts to the left K LRAS shifts to the right K LRAS shifts to the left H LRAS shifts to the right H LRAS shifts to the left N LRAS shifts to the right N LRAS shifts to the left A LRAS shifts to the right A LRAS shifts to the left Using our summary notation: LRAS(Ls,K,H,N,A) An increase in the money supply would increase AD. The increase in K and H would shift the LRAS curve to the right. Without further information, we would be unable to determine the impact on P. On the other hand, if we know that P has risen, then we can infer from this information that AD must have increased faster than the LRAS curve. See graphs below. P P LRAS1 LRAS2 LRAS1 LRAS2 P2 P1 P1 AD2 AD2 AD1 YLR1 YLR2 AD1 Quantity of Real Output YLR1 YLR2 Quantity of Real Output 7. Why does the short-run aggregate-supply curve slope upwards? In other words, why should a decrease in the price level result in a drop in real output in the short run? a. Misperceptions Theory: Sellers base their supply decisions on the relative price of their product. The relative price of their product depends on the price of the product they sell and the price level. If we assume that sellers do not know all prices at all times, then an unexpected drop in the price level may cause some sellers to mistakenly believe that the relative price of the product they sell has declined. This will lead them to reduce output. For example, suppose ALL prices fall by 10%, so that no relative price has changed. Sellers can readily observe that their prices have fallen by 10%, but they may not immediately perceive that other prices have also fallen by 10%. In fact, if some sellers believe (mistakenly) that the price level has not changed, then they will conclude (again, mistakenly) that their relative price has declined by 10%. b. Sticky-Wage Theory—This theory claims that the nominal wage rate (W) is slow to adjust, or is “sticky”, in the short run. For example, suppose a long-term contract fixes the nominal wage for a nontrivial period of time. If the price level now unexpectedly declines, the real wage rate (defined as W/P) will rise. The rise in the cost of hiring labor will reduce the quantity of labor demanded. As a consequence, employment and real output decrease. c. Sticky-Price Theory--- Suppose firms set price at the beginning of each period in anticipation of a certain level of demand for their product. Once price is set, it is costly to change. The costs of changing prices are called menu costs (“costly to print up new menu”). Assume now, due perhaps to an unexpected decline in the money supply, that firms discover that demand for their product is lower than anticipated. In the longrun, of course, this will simply lead to a decline in the price level with no change in real output. In the short run, however, some firms may not immediately adjust their prices due to menu costs. As a consequence, these firms will experience a drop in sales and production. What is the significance of an upward-slopping short-run aggregate-supply curve? It is important to understand the significance of the upward slopping short-run aggregate-supply curve. If the short-run aggregate-supply curve was vertical, then shifts in the aggregate demand curve would have no impact on real output in the short run. This would mean that changes in such variables as the money supply, government spending, or consumer confidence would be unable to explain short-run fluctuations in economic activity, such as recessions. Instead, only shifts in the aggregate supply curve could explain these short-run fluctuations. On the other hand, if the short-run aggregate-supply curve has a positive slope, then unexpected shifts in aggregate demand would indeed lead to short-run fluctuations in real output. What factors shift the short-run aggregate-supply curve? The same variables that shift the long-run aggregate-supply curve also shift the short-run aggregate- supply curve. So changes in labor supply, capital, human capital, natural resources and technological knowledge would all shift the short-run curve. In addition to these shift variables, a change in the expected price level also shifts the short-run aggregatesupply curve. To understand why, it is important to recall that all of the three theories that we discussed in class to explain the positive slope of the short-run aggregate supply curve relied upon unexpected changes in the price level to justify this type of slope. To understand why the expected price level shifts the SRAS curve see the answer to question 8. 8. Use Y = 2000+ (P-PE) to generate numbers in table. For table 1, Y = 2000+(P-100) At P=120, Y = 2000+(120-100)=2020. At P=100, Y = 2000+(100-100)=2000. At P=80, Y=2000+(80100)= 1980. For table 2, we use Y= 2000+(P-80). At P=100, Y=2000+(100-80)=2020. At P=80, Y=2000+(80-80)=2000. At P=60, Y=2000+(60-80)=1980. Table 1 (Expected P=100) Actual P Y . 120 2020 100 2000 80 1980 Table 2 (Expected P = 80) Actual P Y . 100 2020 80 2000 60 1980 Actual P LRAS 120 SRAS (when expected P = 100) 100 SRAS (when expected P =80) 80 60 1980 2000 2020 Quantity of Real Output (Y) As can be seen from the above graph, a change in PE results in the SRAS curve shifting. 9. a. Suppose there is an unexpected drop in the money supply. Since the decrease is unanticipated, there is no change in PE and therefore no shift in the SRAS curve. The drop in money supply causes AD to decrease. The result in the SR is a drop in P and Y. b. Assume that consumer wealth unexpectedly rises. Again,since the increase is unanticipated, there is no change in PE and therefore no shift in the SRAS curve. The increase wealth causes AD to increase. The result in the SR is an increase in P and Y. c. Assume that there is a perfectly anticipated increase in G. Since the change in G is perfectly anticipated, there will be an increase in PE. This causes the SRAS curve to shift to the left (or up in vertical direction). The increase in G itself causes AD to increase. There will be no impact on Y, but P increases. d. New and costly government regulations are imposed on producers. The regulations are temporary. This acts as a decrease in A. Since the regulations are temporary, the LRAS does not shift, but the SRAS does decrease (shifts to the left). The result is a higher P and a lower Y. 9a. 9b. Price Level Price Level LRAS LRAS SRAS SRAS PSR P1 PSR P1 AD2 AD1 AD1 AD2 YSR Y1 Quantity of Real Output Y1 YSR Quantity of Real Output 9d. LRAS Price Level Price Level 9c. LRAS SRAS2 PSR SRAS1 P1 SRAS2 P2 SRAS1 P1 AD2 AD 1 AD YSR Y1 10.Answers to multiple choice questions: 10a.- b. 10b.-a. 10c.-c. 10d.-d. 10e-c. 10f-d. 10g-c. 10h-d. 10i-d. Quantity of Real Output Y1 Quantity of Real Output