Essentials of Economics Study Set 12

Business

Quiz 23 :

Aggregate Demand and Aggregate Supply

Quiz 23 :

Aggregate Demand and Aggregate Supply

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For each of the following events, explain the short-run and long-run effects on output and the price level, assuming policymakers take no action. a. The stock market declines sharply, reducing consumers' wealth. b. The federal government increases spending on national defense. c. A technological improvement raises productivity. d. A recession overseas causes foreigners to buy fewer U.S. goods.
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Effects of an event on price and output in short run and long run:
a.
A sharp fall in the stock market causes shrink in consumers' wealth. In short run, a fall in consumers' wealth will reduce the aggregate demand and causes inward shift in aggregate demand. As a result, price level will fall and, consequently, output level will reduce.
Whereas, in long run a fall in consumers' wealth will reduce the aggregate demand and cause inward shift in aggregate demand. It will lead to fall in price, and consequently, aggregate supply curve will shift rightward to adjust the equilibrium level of output.
b.
The federal government increased expenditure on national defense. Spending on national defense may increase buying weapons and expand the arm force; as a result, employment opportunities in the country will increase and cause the aggregate demand to increase. As aggregate demand increases, price level will increase and cause the aggregate supply to increase. Therefore, in short run, increase in spending on defense will lead to increase in output.
Whereas, in long run, an increase in aggregate demand leads to rise in price level to adjust the disequilibrium between aggregate demand and supply. Hence, level of output will remain unchanged.
c.
A technological improvement increases the productivity; as a result, aggregate supply will increase and cause the price level to fall. This in turn, will raise the aggregate demand. The technological progress raises productivity; hence, output will increase in both short run and long run as well.
d.
A recession in foreign countries reduced the export of U.S. goods and services; as a result, aggregate demand in the U.S. economy reduced and caused the price level to fall. In short run, the fall in price will lead to fall in aggregate supply; hence, output will reduce to keep the aggregate demand and supply in equilibrium.
Whereas, in long run, the fall in aggregate demand will reduce the price level to adjust the disequilibrium in aggregate demand and supply.

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What might shift the aggregate-supply curve to the left? Use the model of aggregate demand and aggregate supply to trace through the short-run and long-run effects of such a shift on output and the price level.
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The aggregate-supply curve shifts to the left because of a decline in the economy's capital stock, labor supply, or productivity, or an increase in the natural rate of unemployment, all of which shift both the long-run and short-run aggregate-supply curves to the left. An increase in the expected price level shifts just the short-run aggregate-supply curve (not the long-run aggregate-supply curve) to the left.
img In a short run, the economy starts in equilibrium at point A. The aggregate-supply curve shifts to the left from AS 1 to AS 2. The new equilibrium is at point B, the intersection of the aggregate-demand curve and AS 2. As time goes on, perceptions and expectations adjust and the economy returns to long-run equilibrium at point A, because the short-run aggregate-supply curve shifts back to its original position.

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For each of the three theories for the upward slope of the short-run aggregate-supply curve, carefully explain the following: a. how the economy recovers from a recession and returns to its long-run equilibrium without any policy intervention b. what determines the speed of that recovery
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a. According to the sticky-wage theory , the economy is in a recession because the unexpected decline in the price level resulted in the raise in real wages; therefore, labor demand is too low. The economy of aggregate supply gets quickly affected by the level of demand. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment.
According to the sticky-price theory , the economy is in a recession because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, and the economy returns to the long-run aggregate-supply curve.
According to the misperceptions theory , the economy is in a recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregate-supply curve.
b. The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust. Here, X axes represents Quantity of output and Y axes represents Price level and demand and supply curves will be shown below diagram.
img

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Suppose firms become very optimistic about future business conditions and invest heavily in new capital equipment. a. Draw an aggregate-demand/aggregate-supply diagram to show the short-run effect of this optimism on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplied changes. b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now, assume there is no change in the long-run aggregate-supply curve.) Explain in words why the aggregate quantity of output demanded changes between the short run and the long run. c. How might the investment boom affect the long-run aggregate-supply curve? Explain.
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Stagflation is caused by
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The idea that economic downturns result from an inadequate aggregate demand for goods and services is derived from the work of which economist?
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In 1939, with the U.S. economy not yet fully recovered from the Great Depression, President Roosevelt proclaimed that Thanksgiving would fall a week earlier than usual so that the shopping period before Christmas would be longer. Explain what President Roosevelt might have been trying to achieve, using the model of aggregate demand and aggregate supply.
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The economy begins in long-run equilibrium. Then one day, the president appoints a new chairman of the Fed. This new chairman is well known for her view that inflation is not a major problem for an economy. a. How would this news affect the price level that people would expect to prevail? b. How would this change in the expected price level affect the nominal wage that workers and firms agree to in their new labor contracts? c. How would this change in the nominal wage affect the profitability of producing goods and services at any given price level? d. How does this change in profitability affect the short-run aggregate-supply curve? e. If aggregate demand is held constant, how does this shift in the aggregate-supply curve affect the price level and the quantity of output produced? f. Do you think this Fed chairman was a good appointment?
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Explain why the long-run aggregate-supply curve is vertical.
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List and explain the three theories for why the short-run aggregate-supply curve slopes upward.
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What might shift the aggregate-demand curve to the left? Use the model of aggregate demand and aggregate supply to trace through the short-run and long-run effects of such a shift on output and the price level.
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Explain why the following statements are false. a. "The aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods." b. "The long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply." c. "If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal." d. "Whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left."
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Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate-demand curve, both, or neither. For each event that does shift a curve, draw a diagram to illustrate the effect on the economy. a. Households decide to save a larger share of their income. b. Florida orange groves suffer a prolonged period of below-freezing temperatures. c. Increased job opportunities overseas cause many people to leave the country.
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