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7.4 Review and Practice

Summary

In this chapter, we outlined the model of aggregate demand and aggregate supply. We saw that the aggregate demand curve slopes downward, reflecting the tendency for the aggregate quantity of goods and services demanded to rise as the price level falls and to fall as the price level rises. The negative relationship between the price level and the quantity of goods and services demanded results from the wealth effect for consumption, the interest rate effect for investment, and the international trade effect for net exports. We examined the factors that can shift the aggregate demand curve as well. Generally, the aggregate demand curve shifts by a multiple of the initial amount by which the component causing it to shift changes.

We distinguished between two types of equilibria in macroeconomics—one corresponding to the short run, a period of analysis in which nominal wages and some prices are sticky, and the other corresponding to the long run, a period in which full wage and price flexibility, and hence market adjustment, have been achieved. Long-run equilibrium occurs at the intersection of the aggregate demand curve with the long-run aggregate supply curve. The long-run aggregate supply curve is a vertical line at the economy’s potential level of output. Short-run equilibrium occurs at the intersection of the aggregate demand curve with the short-run aggregate supply curve. The short-run aggregate supply curve relates the quantity of total output produced to the price level in the short run. It is upward sloping because of wage and price stickiness. In short-run equilibrium, output can be below or above potential.

If an economy is initially operating at its potential output, then a change in aggregate demand or short-run aggregate supply will induce a recessionary or inflationary gap. Such a gap will be closed in the long run by changes in the nominal wage, which will shift the short-run aggregate supply curve to the left (to close an inflationary gap) or to the right (to close a recessionary gap). Policy makers might respond to a recessionary or inflationary gap with a nonintervention policy, or they could use stabilization policy.

Concept Problems

1. Explain how the following changes in aggregate demand or short-run aggregate supply, other things held unchanged, are likely to affect the level of total output and the price level in the short run.

1. An increase in aggregate demand
2. A decrease in aggregate demand
3. An increase in short-run aggregate supply
4. A reduction in short-run aggregate supply
2. Explain why a change in one component of aggregate demand will cause the aggregate demand curve to shift by a multiple of the initial change.
3. Use the model of aggregate demand and short-run aggregate supply to explain how each of the following would affect real GDP and the price level in the short run.

1. An increase in government purchases
2. A reduction in nominal wages
3. A major improvement in technology
4. A reduction in net exports
4. How would an increase in the supply of labor affect the natural level of employment and potential output? How would it affect the real wage, the level of real GDP, and the price level in the short run? How would it affect long-run aggregate supply? What kind of gaps would be created?
5. Give three reasons for the downward slope of the aggregate demand curve.
6. “When the price level falls, people’s wealth increases. When wealth increases, the real volume of consumption increases. Therefore, a decrease in the price level will cause the aggregate demand curve to shift to the right.” Do you agree? Explain.
7. Suppose the economy has a recessionary gap. We know that if we do nothing, the economy will close the gap on its own. Alternatively, we could arrange for an increase in aggregate demand (say, by increasing government spending) to close the gap. How would your views about the degree of price stickiness in the economy influence your views on whether such a policy would be desirable?
8. The cost of hiring workers includes not only payments made directly to workers, that is, wages, but payments made on behalf of workers as well, such as contributions by employers to pension plans and to health-care insurance for employees. How would a decrease in the cost of employer-provided health insurance affect the economy? Using Figure 7.8 "An Increase in Health Insurance Premiums Paid by Firms" as a guide, draw a graph to illustrate your answer.
9. Suppose nominal wages never changed. What would be the significance of such a characteristic?
10. Suppose the minimum wage were increased sharply. How would this affect the equilibrium price level and output level in the model of aggregate demand and aggregate supply in the short run? In the long run?
11. Explain the short-run impact of each of the following.

1. A discovery that makes cold fusion a reality, greatly reducing the cost of producing energy
2. An increase in the payroll tax

Numerical Problems

1. Suppose the aggregate demand and short-run aggregate supply schedules for an economy whose potential output equals \$2,700 are given by the table.

Aggregate Quantity of Goods and Services
Price Level Demanded Supplied
0.50 \$3,500 \$1,000
0.75 3,000 2,000
1.00 2,500 2,500
1.25 2,000 2,700
1.50 1,500 2,800
1. Draw the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves.
2. State the short-run equilibrium level of real GDP and the price level.
3. Characterize the current economic situation. Is there an inflationary or a recessionary gap? If so, how large is it?
4. Now suppose aggregate demand increases by \$700 at each price level; for example, the aggregate quantity of goods and services demanded at a price level of 0.50 now equals \$4,200. Show the new aggregate demand curve, state the new short-run equilibrium price level and real GDP, and state whether there is an inflationary or a recessionary gap and give its size.
2. An economy is characterized by the values in the table for aggregate demand and short-run aggregate supply. Its potential output is \$1,500.

Aggregate Quantity of Goods and Services
Price Level Demanded Supplied
0.50 \$2,500 \$1,500
0.75 2,000 2,000
1.00 1,500 2,300
1.25 1,000 2,500
1.50 500 2,600
1. Draw the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves.
2. State the equilibrium level of real GDP and the price level.
3. Characterize the current economic situation. Is there an inflationary or a recessionary gap? If so, how large is it?
4. Now suppose that nominal wages rise and that the price level required to induce a particular level of total output rises by 0.50. For example, a price level of 1.00 is now required to induce producers to produce a real GDP of \$1,500. Show the new short-run aggregate supply curve, state the new equilibrium price level and real GDP, and state whether there is an inflationary or a recessionary gap and give its size. Why might such a change occur?
3. Suppose the price level in a particular economy equals 1.3 and that the quantity of real GDP demanded at that price level is \$1,200. An increase of 0.1 point in the price level reduces the quantity of real GDP demanded by \$220, and a reduction of 0.1 point would produce an increase in the quantity of real GDP demanded of \$220. Draw the aggregate demand curve and show the price level and quantity of real GDP demanded at three points.
4. Suppose an economy is described by the following aggregate demand and short-run aggregate supply curves. The potential level of output is \$10 trillion.

Aggregate Quantity of Goods and Services
Price Level Demanded Supplied
3.0 \$11.0 trillion \$9.0 trillion
3.4 \$10.8 trillion \$9.2 trillion
3.8 \$10.6 trillion \$9.4 trillion
4.2 \$10.4 trillion \$9.6 trillion
4.6 \$10.2 trillion \$9.8 trillion
5.0 \$10.0 trillion \$10.0 trillion
5.4 \$9.8 trillion \$10.2 trillion
5.8 \$9.6 trillion \$10.4 trillion
6.2 \$9.4 trillion \$10.6 trillion
6.6 \$9.2 trillion \$10.8 trillion
7.0 \$9.0 trillion \$11.0 trillion
1. Draw the aggregate demand and short-run aggregate supply curves.
2. What is the initial real GDP?
3. What is the initial price level?
4. What kind of gap, if any, exists?
5. After the increase in health-care costs, each level of real GDP requires an increase in the price level of 0.8. For example, producing \$9.0 trillion worth of goods and services now requires a price level of 3.8. What is the short-run equilibrium level of real GDP?
6. After the health-care cost increase, what is the new equilibrium price level in the short run?
7. What sort of gap, if any, now exists?
5. According to Alaskan state economist Mark Edwards, the multiplier effect of Alaska’s trade with Japan is such that for every \$1 billion exported from Alaska to Japan another \$600 million is added to the state’s economy.Matt Volz, “Trade Officials Hopeful for Japanese Recovery,” Associated Press and Local Wire, June 22, 2004, BC cycle. Calculate the size of the export multiplier.
6. The Nottinghamshire Research Observatory in England calculated that students who attend Nottingham Technical University spend about £2,760 each in the local economy for a total of £50.45 million. In total, the impact of their spending on the local economy is £63 million.“University Brings in £250m to Economy,” Nottingham Evening Post, November 4, 2004, p. 37. Calculate the size of the student spending multiplier.
7. In Goa, India, the multiplier effect of iron ore exports is calculated to be 1.62.Vidyut Kumar Ta, “Iron Ore Mining Gives Impetus to Goa’s Economy,” Times of India, April 30, 2003. Calculate the impact of an additional 1,000 rupees of iron ore exports on the economy of Goa.