The big picture marcoeconomics 12e parkin chapter 10

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W H AT I S E C O N O M I C S ? 85 AGGREGATE SUPPLY AND AGGREGATE DEMAND** The Big Picture Where we have been: This chapter provides the work horse model, the aggregate supply-aggregate demand model, used to explore answers to the questions about short-run macroeconomic issues The chapter uses the fact established in Chapter 4, that expenditure equals C + I + G + (X – M), to explain the forces that determine aggregate demand It also draws on Chapter 3, demand and supply, for the crucial concepts of equilibrium and the distinction between shifts and movements along demand and supply curves Where we are going: This chapter provides a description of the AS-AD model The treatment parallels that of the demand and supply model in Chapter That is, the curves are defined and the reasons for their slopes and the factors that shift them are explained But the curves are not formally derived The next chapter more formally derives the aggregate demand curve from the aggregate expenditure curve It lays out the aggregate expenditure model, explains the multiplier effect of changes in investment, describes the adjustment process that moves the economy toward the AD curve, and derives the AD curve from the AE equilibrium Then Chapters 12, 13, and 14 make use of the aggregate supply-aggregate supply framework to explore business cycles and inflation, fiscal policy, and monetary policy N e w i n t h e Tw e l f t h E d i t i o n All the data are updated through 2014 and a discussion of the World Economy Headwinds in Economics in Action has been added The Economics In The News feature has a 2014 article about stronger than expected rebound in the U.S economy, which applies the AD-AS model The Worked Problem presents aggregate demand and short-run aggregate supply schedules and then asks the 85 86 short-run equilibrium real GDP and price level It also asks the effect of an increase in aggregate demand The solutions to the problems use both the aggregate demand and short-run aggregate supply schedules and an AD-SAS figure To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems 86 Lecture Notes Aggregate Supply and Aggregate Demand   The aggregate supply-aggregate demand (AS-AD) model explains how real GDP and the price level are determined The model also helps explains the factors that determine inflation and the business cycle Tell students that there is heated debate among economists on the most important influences in the macro economy and how to model those influences Economists as a group are ambivalent about the aggregate supply-aggregate demand (AS-AD) model Real business cycle theorists, who like to build their models from the base of production functions and preferences, don’t use the model because the AS and AD curves are not independent Technological change shifts both the AS and AD curves simultaneously and in complicated ways New Keynesian economists have dropped the model in favor of a dynamic variant that places the inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of potential GDP) on the x-axis Despite the controversy, the AS-AD model is the key macroeconomic model for most economists The model plays a similar role in the organization of the macroeconomics to that played by the demand and supply model in microeconomics The author does a good job of using the ASAD model to explain various schools of thought The AS-AD model is the best model currently available for introducing students to macroeconomics It enables them to gain insights into the way the economy works, to organize their study of the subject, and to understand the debates surrounding the effects of policies designed to improve macroeconomic performance Devoting at least a week of lecture time to the AS-AD model is worthwhile Your goal at this point in the course is to help them understand the components of the model intuitively and to put the model to work using some of its more simple and obvious features I Aggregate Supply The quantity of real GDP supplied is the total quantity of goods and services, valued in constant dollar prices, that firms plan to produce in a given time period This amount depends on the quantity of labor employed, the capital stock, and the state of technology In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP Long-Run Aggregate Supply   The long-run aggregate supply curve the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP As illustrated in the figure, the LAS curve is vertical at the level of potential GDP ($13 trillion in the figure), showing that potential GDP does not depend on the specific price level In the long run, the wage rate and other resource prices change in proportion to the price level So moving along the LAS curve both the price level and the money wage rate change by the same percentage is A G G R E G A T E S U P P LY A N D A G G R E G AT E D E M A N D Short-Run Aggregate Supply   The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate, the prices of other resources, and potential GDP remain constant As illustrated in the figure, the SAS curve is upward sloping This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor firms employ and hence increasing the real GDP firms produce Difference between LAS and SAS: The distinction between the LAS and the SAS comes about by assuming that resource and output prices adjust at different rates Ask the class, “When there is an increase in demand, what you think adjusts first, prices of goods on the shelves at Wal-Mart or wages of employees at Wal-Mart?” By discussing out the potential lag times in resource price adjustment, you have opened up a hotly contested item among economists How long is that lag time? Tell the students that there are different schools of thought about this issue and during the term we will see how different assumptions yield different answers Movements Along the LAS and SAS Curves and Changes in Aggregate Supply Movements Along the Curves  When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LAS curve  When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SAS curve Shifts in the Curves  When potential GDP increases, both long-run and short-run aggregate supply increase and the LAS and SAS curves shift rightward Potential GDP increases when the full employment quantity of labor increases, the quantity of capital increases, or technology advances  Short-run aggregate supply changes and the SAS curve shifts when there is a change in the money wage rate or other resource prices A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward The flavor of the Classical-Keynesian controversy If you want to convey the flavor of one of the biggest controversies in macroeconomics, you can so at this early stage of the course by using only the aggregate supply curves The difference between the upwardsloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly Along the SAS curve: You cannot repeat yourself too many times about this topic: Moving along the SAS curve, resource prices are fixed Point out that this is the same assumption for the “micro” supply curve In particular, if there is an increase in the money wage rate at the Pepsi plant, the supply curve for Pepsi shifts leftward That same principle gets applied to all goods and services in the AS-AD model so an increase in the money wage rate shifts the SAS curve leftward 99 100 CHAPTER 10 Along the LAS curve: Students seem comfortable with the idea that the SAS curve has a positive slope but they seem less at ease with the vertical LAS curve Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified Though you not “need” to emphasize this point, what the LAS curve illustrates is that the real economy is independent of money prices! II Aggregate Demand   The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I) , government expenditure (G), and net exports (X  M), or Y = C + I + G + (X  M) Buying plans depend on many factors including:  The price level  Expectations  Fiscal policy and monetary policy  The world economy The Aggregate Demand Curve  Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded The relationship between the quantity of real GDP demanded and the price level is called aggregate demand As the figure shows, the AD curve is downward sloping  The negative relationship between the price level and the quantity of real GDP demanded reflects the wealth effect (when the price level rises, real wealth decreases and so people decrease consumption) and substitution effects (first, the intertemporal substitution effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded) Keep it simple You know that the AD curve is a subtle object—an equilibrium relationship derived from simultaneous equilibrium in the goods market and the money market This description of the AD curve is not helpful to students in the principles course and is a topic for the intermediate macro course At the same time that we want to simplify the aggregate demand story, we also want to avoid being misleading The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of aggregate demand A major problem with the AD curve is that a change in the price level that brings a movement along the curve is not a strict ceteris paribus event A change in the price level A G G R E G A T E S U P P LY A N D A G G R E G AT E D E M A N D changes the quantity of real money, which changes the interest rate Indeed, this chain of events is one of the reasons for the negative slope of the AD curve In telling this story, we must be sensitive to the fact that the students don’t totally appreciate the ceteris paribus condition We must provide intuition with stories such as the Maria stories in the textbook Income equals expenditure on the AD curve Some instructors want to emphasize a second and more subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real GDP That is, the AD curve is not drawn for a given level of income but for the varying level of income that equals the level of planned expenditure If you want to make this point when you first introduce the AD curve, you must cover the AE model in the next chapter before you cover this chapter (The material is written in a way that permits this change of order.) If you not want to derive the AD curve from the equilibrium of the AE model, don’t even mention what’s going on with income along the AD curve Silence is vastly better than confusion You can pull this rabbit out of the hat when you get to the next chapter if you’re covering the material in the order presented in the textbook Changes in Aggregate Demand  Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve Factors that change aggregate demand are:  Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward  Fiscal policy and monetary policy: The government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy Tax cuts or increased transfer payments increase disposable income (aggregate income minus tax payments plus transfers) and thereby increase consumption expenditure and aggregate demand Increased government expenditures increase aggregate demand Monetary policy consists of changes in interest rates and in the quantity of money in the economy An increase in the quantity of money and lower interest rates increase aggregate demand  The world economy: Exchange rates and foreign income affect net exports (X  M) and, therefore, aggregate demand A decrease in the exchange rate or an increase in foreign income increases aggregate demand III Explaining Macroeconomic Trends and Fluctuations Short-Run and Long-Run Macroeconomic Equilibrium  Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied This equilibrium is determined where the AD and SAS curves intersect  If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices  If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices Short-run macroeconomic equilibrium Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend Describe the convergence process using the mechanism laid out in the textbook In that process, firms always produce the profitmaximizing quantities—the economy is on the SAS curve If they can’t sell everything they produce, firms lower prices and cut production Similarly, they can’t keep up with sales and 101 102 CHAPTER 10 inventories are falling, firms raise prices and increase production These adjustment processes continues until firms are selling their profit-maximizing output  Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP— equivalently, as the figure shows, when the economy is on its long-run aggregate supply curve The figure shows the long-run macroeconomic equilibrium at a real GDP of $16 trillion and a price level of 110 From the short run to the long run Explain that market forces move the money wage rate to the long-run equilibrium level At money wage rates below the long-run equilibrium level, there is a shortage of labor, so the money wage rate rises and employment decreases At money wage rates above the long-run equilibrium level, there is a surplus of labor, so the money wage rate falls and employment increases At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labor and the money wage rate remains constant and employment is constant at its full employment level Economic Growth and Inflation   Economic growth occurs when potential GDP increases so that the LAS curve shifts rightward Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve In the long run, only growth in the quantity of money makes the AD curve continually shift rightward The Business Cycle The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP  A below full-employment equilibrium is a macroeconomic equilibrium in which potential GDP exceeds real GDP The gap between real GDP and potential GDP is the output gap With a below-full employment equilibrium, the gap is called a recessionary gap A recessionary gap occurs when the SAS curve and the AD curve intersect to the left of the LAS curve  An above full-employment equilibrium is a macroeconomic equilibrium in which real GDP exceeds potential GDP The amount by which real GDP exceeds potential GDP, the output gap, is called an inflationary gap An inflationary gap occurs when the SAS curve and the AD curve intersect to the right of the LAS curve  A full-employment equilibrium is a macroeconomic equilibrium in which real GDP equals potential GDP  The figure below to the left shows a below-full employment equilibrium with a recessionary gap of $1 trillion The figure on the right shows an above fullemployment equilibrium with an inflationary gap of $1 trillion A G G R E G A T E S U P P LY A N D A G G R E G AT E D E M A N D Point out to the students that to simplify analysis of the business cycle, economists typically abstract from the long-term persisting increases in the LAS curve and AD curve that generate economic growth and inflation, respectively So, by fixing the LAS curve when considering business cycle fluctuations, economists are looking at short-term movements around a slower moving long-run equilibrium level of output Explain to the students that one reason to abstract from these long-term movements is simply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones A second reason is the standard view that short-term movements around the LAS are driven by different economic forces than the persisting long-run shifts in the LAS curve So abstracting from long-term growth in order to focus on business cycle fluctuations simplifies matters without any loss of relevant details An Economics in Action feature discusses the “World Economy Headwinds”—slowing real GDP growth—that threaten to decrease U.S exports and thereby leave a recessionary gap in the United States Fluctuations in Aggregate Demand An increase in aggregate demand shifts the AD curve rightward, as in the figure where the aggregate demand curve shifts from AD0 to AD1 In 103 104 CHAPTER 10 the short run, a rightward shift of the AD curve leads to movement along the SAS curve so that both the price level and real GDP increase In the figure the economy moves from an initial equilibrium at point a with real GDP equal to potential GDP of $16 trillion and a price level of 100 to point b with real GDP of $17 trillion and a price level of 105 But in the long run, the higher price level and tight labor market lead to an increase in the money wage rate Short-run aggregate supply decreases and the SAS curve shifts leftward, in the figure from SAS0 to SAS The long-run equilibrium is reached when the short-run aggregate supply has decreased enough so that the economy is back producing at potential GDP, which in the figure occurs when the economy moves from b to point c In the long run, the increase in aggregate demand has no effect on real GDP—it has returned to potential GDP, $16 trillion in the figure and only results in a higher price level—which has risen from 100 to 110 in the figure Shifting the SAS curve Reinforce the movement toward long-run equilibrium with a curve-shifting exercise Take the case where the AD curve shifts rightward The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult But the notion that the SAS curve shifts leftward as time passes is difficult for many students The trick to making this idea clear is to spend enough time when initially discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve Once the students see this point, they can understand that, as input prices increase in response to the higher level of (output) prices, the SAS curve shifts leftward Avoid confusing students by using “up” to correspond to a decrease in SAS But point out that that when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level Most students find it easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve vertically upward In the figure above, instead of using identifying the short-run aggregate supply curve with SAS0you might use SASW=$10 with the explanation that along this SAS curve the money wage rate, W, is fixed at $10/hour Then, rather than label the new short-run aggregate supply curve SAS 1, can identify it as SASW=$11 You can now show your students the qualitative point that the money wage rate has increased and you can show them the quantitative point that the 10 percent increase in the price level (from 100 to 110) lead to a 10 percent increase in the money wage rate Fluctuations in Aggregate Supply Some business cycle fluctuations are driven by shifts in short-run aggregate supply An increase in energy prices decreases the short-run aggregate supply and shifts the SAS curve leftward The price level increases and real GDP decreases The combination of recession and higher inflation is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks IV Macroeconomic Schools of Thought There is a fair degree of consensus among mainstream economists about economic growth and inflation, although there is still immense debate about the business cycle The importance of macroeconomic issues and the complexities of economic systems mean that there are strong incentives to speak knowledgeably about macroeconomics, but it is difficult for most people to evaluate whether the speaker is truly knowledgeable or a charlatan Mainstream economic theories are completely thought out and fully articulated Thus, one should be wary of anyone who confidently rejects that one of these mainstream theories as “just plain wrong.” A G G R E G A T E S U P P LY A N D A G G R E G AT E D E M A N D The Classical View    A classical macroeconomist believes that the economy is self-regulating and that it is always at full employment A new classical view is that business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change The uneven pace of technological advancement are the main source of business cycle fluctuations There is no distinct short-run aggregate supply curve because the economy is always producing at potential GDP Classical economists emphasize that taxes blunt people’s incentives to work, so the most the government should to affect the business cycle is to keep taxes low The Keynesian View     A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle fluctuations Because money wages are sticky (slow to adjust), especially in the downward direction, the economy can remain mired in a recession A modern version of the Keynesian view known as the new Keynesian view holds that not only is the money wage rate sticky but that the prices of some goods and services are also sticky Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment Although Keynes agreed that the economy would return to its potential in the long run, he stated, “In the long run, we are all dead” Keynes believed that because of the interaction between financial markets, the price level, and the labor market, there was no inherent tendency of the market system to return quick enough to potential GDP following an aggregate demand shock The role of the government, in Keynes’ view, was not to replace markets with central planning, but to use stabilization policies to help the macroeconomy find equilibrium at potential GDP Keynes’ analogy was that market capitalism in the Great Depression was like a car with a broken alternator Fiscal policy would give the economy a jump-start when aggregate demand was inadequate Keynes worried that without active aggregate demand management, high unemployment would lead to a breakdown of capitalism, with revolution leading to totalitarianism in the form of communism or fascism The Monetarist View     A monetarist macroeconomist believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady Aggregate demand fluctuations driven by monetary policy mistakes are the main source of business cycle fluctuations There is a short-run aggregate supply curve because money wages are sticky The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path Beyond these policies, however, the government should not undertake active stabilization policy The Economics in the News detail discusses real GDP growth in the second quarter of 2014 This growth was more rapid than expected, which is analyzed in terms using the AD-AS model 105 106 CHAPTER 10 Additional Problems Explain and draw a graph to illustrate how a depreciation of the dollar changes the short-run equilibrium real GDP and price level Suppose the government creates a fiscal stimulus by sending people checks representing temporary tax cuts a Explain and draw a graph to illustrate the effect of this fiscal stimulus payments on real GDP and the price level in the short run b At which type of short-run equilibrium would the government want to use this policy? c Which macroeconomic school of thought would justify this policy? d If the government used this policy when the economy was at full employment, explain what would happen in the long run e Draw a graph to illustrate your answer to d What is stagflation? Explain how the increase in the price of oil can cause stagflation and draw a graph to illustrate this outcome Solutions to Additional Problems The depreciation of the dollar increases U.S net exports, which increases U.S aggregate demand The increase in aggregate demand increases real GDP and raises the price level These changes are illustrated in Figure 10.1 In this figure the aggregate demand curve shifts rightward from AD0 to AD1 As a result real GDP increases, from $16.0 trillion to $16.2 trillion, and the price level rises, from 119 to 121 A G G R E G A T E S U P P LY A N D A G G R E G AT E D E M A N D a The fiscal stimulus check increased households’ consumer expenditure The increase in consumption expenditure boosted aggregate demand so the aggregate demand curve shifted rightward Figure 10.2 shows the effect of this change The aggregate demand curve shifts rightward from AD0 to AD1 As a result real GDP increases, in the figure from $16 trillion to $16.1 trillion, and the price level rises, in the figure from 119 to 121 b The government wants to use this type of policy when the economy is in a below fullemployment equilibrium with a recessionary gap c Keynesian economists would support this policy d If this stimulus policy was used when the economy was at full employment, in the short run the price rises and real GDP increases But in the long run the money wage rate rises to reflect the higher price level The rise in the money wage rate decreases short-run aggregate supply Ultimately in the long run real GDP returns to potential GDP so there is no long-run change in real GDP The price level, however, rises as short-run aggregate supply decreases So the price level in the long-run is higher than in the short run e Figure 10.3 shows the long-run changes described in the previous answer After the initial shift in the aggregate demand curve from AD0 to AD1, the price level has risen As a result the money wage rate rises so that the short-run aggregate supply curve shifts leftward, in the figure from SAS0 to SAS In turn the price level rises still more, in the figure ultimately to 122 Real GDP, however, decreases and eventually returns to its initial level, which is potential GDP and in the figure is $16.0 trillion 107 108 CHAPTER 10 Stagflation is the combination of recession and inflation Increases in the price of oil can decrease aggregate supply The decrease in aggregate supply raises the price level—so there is inflation—and decreases real GDP—so there is a recession Figure 10.4 illustrates these results In this figure the aggregate supply curve shifts leftward from AS0 to AS1 As a result real GDP decreases from $16.0 trillion to $15.8 trillion and the price level rises, from 118 to 120 Additional Discussion Questions 11 “The demand curves for all products have negative slopes For instance, the demand curves for milk, automobiles, personal computers, and shirts all have negative slopes Therefore, because the aggregate demand curve shows the demand for all products, it too must have a negative slope.” Comment on this assertion The assertion is incorrect Demand curves for goods and services such as milk and so forth have negative slopes because the price measured along the vertical axis is a relative price; that is, it is the price of the good or service relative to the price of another good or service As a result, the demand curve for these goods or services captures the possibility of substitution: A higher price for a gallon of milk causes consumers to substitute away from milk and toward other beverages, such as water or soda, whose price has not risen The price level, which is the variable along the vertical axis for the aggregate demand curve, is not a relative price It is the average of all prices When the price level rises, all domestic prices have risen so the only substitution possibility is toward imported goods and over time (the intertemporal substitution effect) These substitutions offer reasons why the aggregate demand curve has a negative slope Another, possibly more important reason for the negative slope is the wealth effect: When the price level rises and nothing else changes, people’s real wealth decreases When real wealth decreases, people’s consumption expenditure decreases so that the aggregate quantity of goods and services demanded decreases 12 Explain why the SAS curve slopes upward and the LAS curve is vertical The SAS curve applies in the short run; the LAS curve applies in the long run When the price level rises, firms find that the prices of the goods and services they produce have risen In the short run the money wage rate (and other costs) not change With higher prices and unchanged costs, firms find it profitable to increase their production Hence in the short run the quantity of real GDP produced increases, which means that along the SAS curve a higher A G G R E G A T E S U P P LY A N D A G G R E G AT E D E M A N D price level leads to an increase in the quantity of real GDP supplied However in the long run money wage rates adjust to reflect the higher price level In the long run the money wage rate and price level rise in the same proportion In the long run, with both higher prices and higher costs, firms return to their initial level of production Hence in the long run the quantity of real GDP produced does not change, which means that along the LAS curve a higher price level leads to no change in (potential) GDP 13 When the equilibrium real GDP is below potential GDP, how does the unemployment rate compare with the natural rate? What is the result of this state of affairs that restores the long-run equilibrium? When real GDP is less than potential GDP, the unemployment rate exceeds the natural rate In the labor market, the high unemployment rate forces the money wage rate lower As the money wage rate falls, firms hire more workers and short-run aggregate supply increases The increase in short-run aggregate supply increases real GDP Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP At this point, long-run equilibrium is reached and the money wage rate no longer falls so that all adjustments cease 14 Explain how an increase in money wages affects the SAS curve Why does a change in money wages affect only the SAS curve and not the LAS curve? An increase in the money wage rate means that firms’ costs have risen At a given price level, the increase in their costs causes firms to decrease the quantity of goods and services they produce The quantity of real GDP produced decreases and the SAS curve shifts leftward The change in the money wage rate does not affect the quantity of production along the LAS curve because along that curve both the money wage rate and price level change in the same proportion In other words, it is not possible to assume a given price level to investigate the effect of an increase in the money wage rate along the LAS curve because along that curve both variables change And when both the price level and money wage rate change by the same proportion, firms will not change the quantity of real GDP they produce 15 If the government spends more money by buying more goods and services, is this change an example of fiscal policy or monetary policy? When the government increases its expenditure by purchasing more goods and services, the government is engaging in fiscal policy 16 What is a recessionary gap? How does the economy adjust to eliminate a recessionary gap? A recessionary gap occurs when actual real GDP is less than potential GDP With a recessionary gap the unemployment rate exceeds the natural rate In the labor market, the high unemployment rate forces the money wage rate lower As the money wage rate falls, firms hire more workers and short-run aggregate supply increases The increase in short-run aggregate supply increases real GDP Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP At this point, longrun equilibrium is reached and the money wage rate stops falling so that short-run aggregate supply stops increasing 109 110 CHAPTER 10 ... students the qualitative point that the money wage rate has increased and you can show them the quantitative point that the 10 percent increase in the price level (from 100 to 110) lead to a 10 percent... aggregate demand shifts the AD curve rightward, as in the figure where the aggregate demand curve shifts from AD0 to AD1 In 103 104 CHAPTER 10 the short run, a rightward shift of the AD curve leads... services in the AS-AD model so an increase in the money wage rate shifts the SAS curve leftward 99 100 CHAPTER 10 Along the LAS curve: Students seem comfortable with the idea that the SAS curve
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