Deck 11: The Aggregate-Demandaggregate-Supply Model

Question 1

Show the impact of a reduction in the money supply on the economy. You may assume that the economy begins in long-run equilibrium. Be sure to show the impact on output and the price level in both the short and the long run.

Answer 1

In the long run equilibrium occurs at the point of intersection of aggregate demand curve, long run aggregate supply (LRAS) curve and short run aggregate supply curve (SRAS). It is shown in the figure below.
Figure (a)
LRAS curve is a vertical straight-line implying that aggregate supply is independent of changes in price level. SRAS curve is upward sloping implying that in the short run aggregate supply can be increased by way of overtime work, if there is an increase in demand and price level.
In the aggregate demand-aggregate supply model a contractionary monetary policy leads to a leftward shift in aggregate demand. In the short run, it will result in a temporary fall in production and output and equilibrium happens at the point of intersection of SRAS and the new aggregate demand curves. It causes a temporary reduction in output and price level. Equilibrium occurs at less than full employment level.
However, in the long run SRAS curve shifts rightwards gradually and this causes a permanent reduction in the price level. Output increases and restored at the full employment level. It is shown in figure (b).
Figure (b)
Initially the economy is at long run full employment equilibrium at point 1. It is the point of intersection of SRAS1, LRAS and Ad1 curves. If there is a reduction in money supply, the aggregate demand will be reduced to Ad2. The new equilibrium occurs at point 2 where SRAS1 curve and Ad2 curves intersect. Output falls to Ys and price level comes down to P2. However, gradually the economy moves to the long run equilibrium at point 3. Supply curve shifts to SRAS2. The long run equilibrium occurs at the point of intersection of SRAS2, LRAS and Ad2 curves. There is a permanent reduction in price level to P3. Output again increases to full employment level Yf.

Question 2

Suppose that the government imposed a $1 tax each time someone used an ATM. How would this tax affect output and the price level in the short and the long run?

Answer 2

In case a government imposes a tax of $ 1 for each time ATM use then definitely it will have an impact on the velocity of the money. The velocity of the money will be restricted. Since the transaction is more costly hence it may affect the money supply in the short run. And hence as a result interest rate might move upward and short run equilibrium of the economy may be altered.
But in case of the long run economic performance with the process of adjustment in between different economic variables the short run fluctuations will be adjusted and the long run equilibrium will be reestablished.

Question 3

In the late 1990s, a huge increase in the value of the stock market increased the wealth of many consumers. Show how this increase in wealth affected consumption spending, aggregate demand, output, and the price level in the short and the long run.

Answer 3

In 1900s, due to increase in the stock value, consumers' wealth had increase drastically. The possible impact of increase in wealth can be explained on the following,
Consumption spending : Since wealth is a part of disposable income, therefore in the short-run the consumers have become relatively rich, and hence consumption spending increased.
Aggregate Demand : Since aggregate demand constitutes consumption spending, therefore with the increase in consumption spending, aggregate demand rises. In graph increase in aggregate demand shift the AD curve rightward.
Output and Price : In the short run, the increase in aggregate demand causes price and output to rise. This is because of scarcity of resources and the overemployment of the existing machines. But in the long-run, increase pressure in the supply factors causes cost of production to rise as a result output falls back to its potential level but with the increase in price.
Let's analyses the impact of increase in stock market on graph.
Initially suppose the economy was at equilibrium E, corresponding to which real output in the economy was Q and general price was P. In the short run, as the wealth increase, consumption spending increases, which causes aggregate demand curve AD to shift to AD'.
Now the new equilibrium level is E', corresponding to which real output is Q' and price is P'. At this equilibrium, output is not sustainable because of overemployment of resources, and workers will revise their wage upward in the presence of rising price. Hence in the long-run, supply side cost will increase, which will push the AS curve backward to the left to AS'.
The decrease in aggregate supply will bring the economy back to equilibrium level, but with higher price P''.

Question 4

Suppose continued terrorist activity forces business fi rms and government to devote additional resources to law enforcement and military force, causing a permanent reduction in business productivity. Show the impact in the AD-AS model on the long-run level of output and the price level. What is likely to happen to consumption and investment as a result?

Question 5

What are the two equilibrium conditions needed to determine points on the AD curve?

Question 6

Explain the major components of the market for goods and services. What key macroeconomic variables infl uence spending on those components?

Question 7

What does it mean to say the economy is "at fullemployment output"?

Question 8

Why does the SRAS curve slope upward?

Question 9

Why is the LRAS curve vertical?

Question 10

How does the economy adjust from the short run, in which the AD curve intersects the SRAS curve at a point that is not on the LRAS curve, to the long run, in which all three curves intersect at a common point?

Question 11

What are the consequences of an increase in the money supply on output and the price level? Does your answer depend on where the economy starts (whether it is in long-run equilibrium or not)?

Question 12

What were some of the inconsistencies that made economists skeptical of the value of large, structural macroeconomic models?

Question 13

How did the overconfi dence of macroeconomists after the long expansion of the 1960s lead to the infl ation of the 1970s?

Question 14

What is the Lucas critique, and how did it expose a fatal fl aw in large, structural macroeconomic models?

Question 15

Describe how a decrease in government defense spending causes the AD curve to shift. What is the effect on the price level and output in the short run? In the long run?