# Macroeconomics Study Set 63

## Quiz 18 :Extending the Analysis of Aggregate Supply

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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?
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Laffer curve illustrates the relationship between tax rate and tax revenue. It points out that an economy has an optimal tax rate that maximizes tax revenue. Tax rates that are above or below the optimal tax rate reduce tax revenue.
Supply-side economics pointed out that level of inflation is determined largely by the change in aggregate supply. Government tax policies can affect the shifts of the short-run and long run aggregate supply curves, which will consequently affect inflation, unemployment, and output.
Determining the economy's location on the curve helps identifying if the current tax rate is below or above the optimal tax rate. If it is below the optimal tax rate, government should increase tax rate; and if it is above the optimal tax rate, government should decrease tax rate.

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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 froM120 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 froM120 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? Free Essay Answer: Answer: The figure of the question is reproduced below. In the short run, the economy moves along AS2. When price increases froM120 to 130, output increases from$870 to $890. In the long run, as price increases nominal wages adjust to a higher level and firms cut output back to the full-employment level of$870. Aggregate supply curve shifts leftward to AS3.
In the short run, the economy moves along AS2. When price decreases froM120 to 110, output decreases from $870 to$850.
In the long run, as price decreases nominal wages adjust to a lower level and firms increase output back to the full-employment level of $870. Aggregate supply curve shifts rightward to AS1. The long-run level of output is the full-employment level, which is$870.

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Suppose that for years East Confetti's short-run Phillips Curve was such that each 1 percentage point increase in its unemployment rate was associated with a 2 percentage point decline in its inflation rate. Then, during several recent years the short run pattern changed such that its inflation rate rose by 3 percentage points for every 1 percentage point drop in its unemployment rate. Graphically, did East Confetti's Phillips Curve shift upward or did it shift downward?
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Graphically the Phillips Curve shifted upward, since inflation changed by a larger amount for 1 percentage change of unemployment. Graph 1.1 below shows the change of Phillips Curve from PC 1 to PC 2.
Graph 1.1: Phillips curve
From Graph 1.1, observe that initially the gap between the inflation and unemployment iS1% and after the years, it waS3%. This led to the difference between PC 1 and PC 2.

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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?
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Suppose that over a 30-year period Buskerville's price level increased from 72 to 138 while its real GDP rose from $1.2 trillion to$2.1 trillion. Did economic growth occur in Buskerville? If so, by what average yearly rate? Did Buskerville experience inflation? If so, by what average yearly rate? Which shifted rightward faster in Buskerville: its long-run aggregate supply curve (ASLR) or its aggregate demand curve (AD)?
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Suppose the full-employment level of real output (Q) for a hypothetical economy is \$250 and the price level (P) initially iS100. 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 froM100 to 125 because of an increase in aggregate demand? What if the price level unexpectedly falls froM100 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 froM100 to 125? When it falls froM100 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.
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Distinguish between the short run and the long run as they relate to macroeconomics. Why is the distinction important?
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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
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LAST WORD?On average, does an increase in taxes raise or lower real GDP? If taxes as a percent of GDP go uP1 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?
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ADVANCED ANALYSIS Suppose that the equation for a particular short-run AS curve is P = 20 +.5 Q , where P is the price level and Q is real output in dollar terms. What is Q if the price level iS120? Suppose that the Q in your answer is the full-employment level of output. By how much will Q increase in the short run if the price level unexpectedly rises froM120 to 132? By how much will Q increase in the long-run due to the price level increase?
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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 policya.?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.
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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
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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?
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