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
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.
(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.
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 long-run, 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.
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 after-tax 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.
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?
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?