Answers to review quizzes marcroeconomics 12e parkin chapter 10

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W H AT I S E C O N O M I C S ? 171 AGGREGATE SUPPLY AND AGGREGATE DEMAND** Answers to the Review Quizzes Page 283 (page 691 in Economics) If the price level and the money wage rate rise by the same percentage, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level and the money wage rate rise by the same percentage, there is no change in the quantity of real GDP supplied and a movement occurs up along the LAS curve If the price level rises and the money wage rate remains constant, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level rises and the money wage rate remains constant the quantity of real GDP supplied increases and the economy moves along the SAS curve If potential GDP increases, what happens to aggregate supply? Does the LAS curve shift or is there a movement along the LAS curve? Does the SAS curve shift or is there a movement along the SAS curve? If potential GDP increases both long-run aggregate supply and short-run aggregate supply increase and the LAS curve and SAS curve shift rightward If the money wage rate rises and potential GDP remains the same, does the LAS curve or the SAS curve shift or is there a movement along the LAS curve or the SAS curve? If the money wage rate rises and potential GDP remains the same there is a decrease in short-run aggregate supply and no change in long-run aggregate supply The SAS curve shifts leftward and the LAS curve is unchanged Page 287 (page 695 in Economics) What does the aggregate demand curve show? What factors change and what factors remain the same when there is a movement along the aggregate demand curve? 171 172 The aggregate demand curve shows the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same When there is a movement along the aggregate demand curve, the price level changes and other factors such as expectations, fiscal and monetary policy, and the world economy remain the same Why does the aggregate demand curve slope downward? The aggregate demand curve slopes downward because of the wealth effect and two substitution effects First, a rise in the price level decreases real wealth, which brings an increase in saving and a decrease in spending—the wealth effect Second, a rise in the price level raises the interest rate, which decreases borrowing and spending—an intertemporal substitution effect as people decrease current spending in favor of future spending—and increases the price of domestic goods and services relative to foreign goods and services, which decreases exports and increases imports—an international substitution effect How changes in expectations, fiscal policy and monetary policy, and the world economy change aggregate demand and the aggregate demand curve? Aggregate demand increases and the AD curve shifts rightward if: expected future income, expected future inflation, or expected future profits increase; government expenditure increases or taxes are cut; the quantity of money increases and the interest rate is cut; the exchange rate falls; or foreigners’ income increases The reverse changes decrease aggregate demand and shift the AD curve leftward Page 293 (page 701 in Economics) Does economic growth result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply? Economic growth results from increases in long-run aggregate supply Economic growth occurs because the quantity of labor increases, capital is accumulated and there are technological advances over time All three of these factors increase potential GDP and shift the LAS curve rightward Does inflation result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply? Inflation results from increases in aggregate demand that exceed the increase in long-run aggregate supply As the aggregate demand curve shifts rightward the price level rises Increases in AD that exceed increases in LAS produce inflation Describe three types of short-run macroeconomic equilibrium Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied There are three types of shortrun equilibrium: below full-employment equilibrium where a recessionary gap exists with real GDP less than potential GDP; above full-employment equilibrium where an inflationary gap exists with real GDP greater than potential GDP; fullemployment equilibrium where no gap exists and real GDP equals potential GDP How fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP? Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations in real GDP around potential GDP For instance, starting from full employment, a decrease in aggregate demand decreases the price level and real GDP and creates a recessionary gap In the long run the money wage rate (and the money prices of other resources) falls so that short-run aggregate supply increases and the economy returns to its full employment equilibrium Starting from full employment, a decrease in short-run aggregate supply decreases real GDP and 172 W H AT I S E C O N O M I C S ? 173 raises the price level The fall in real GDP combined with a rise in the price level is a phenomenon called stagflation Page 295 (page 703 in Economics) What are the defining features of classical macroeconomics and what policies classical macroeconomists recommend? Classical macroeconomists believe that the economy is self-regulating and always at full employment Classical macroeconomists assert that the proper government policy is to minimize the disincentive effects of taxes on employment, investment, and technological change What are the defining features of Keynesian macroeconomics and what policies Keynesian macroeconomists recommend? Keynesian macroeconomists believe that if the economy was left alone, it would rarely operate at full employment To achieve and maintain full employment the economy needs active help from fiscal and monetary policy Aggregate demand fluctuations combined with a very sticky money wage rate are the major sources of the business cycle Keynesian macroeconomists assert that active fiscal and monetary policy, designed to offset fluctuations in aggregate demand, are the proper government policies What are the defining features of monetarist macroeconomics and what policies monetarist macroeconomists recommend? Monetarists believe that the economy is self-regulating and will typically operate at full employment if monetary policy is not erratic and the money growth rate is kept steady The major source of business cycle fluctuations are similar to the Keynesian view, that is, changes in aggregate demand combined with a sticky money wage rate However, according to monetarists, the changes in aggregate demand are the result of fluctuations in the growth rate of money caused by the Federal Reserve Monetarists assert that the proper government policies are low taxes, to avoid the disincentive effects stressed by classical macroeconomists, and steady monetary growth 173 Answers to the Study Plan Problems and Applications Explain the influence of each of the following events on the quantity of real GDP supplied and aggregate supply in India and use a graph to illustrate • U.S firms move their call handling, IT, and data functions to India Moving call-handling, IT, and data functions to India increases short-run and long-run aggregate supply because it increases the amount of employment at full employment and (probably) also increases the capital stock As Figure 10.1 shows, both the short run aggregate supply curve and long-run aggregate supply curve shift rightward, from SAS to SAS and from LAS0 to LAS1 • Fuel prices rise The rise in fuel prices raises firms’ costs Short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward Long-run aggregate supply does not change Figure 10.2 shows the leftward shift of the short-run aggregate supply curve from SAS to SAS1 • Wal-Mart and Starbucks open in India When Starbucks and Wal-mart open in India, short-run and long-run aggregate supply increase When these stores open, employment at full employment increases and India’s capital stock increases Both the short-run and long-run aggregate supply curves shift rightward, as illustrated in Figure 10.1 • Universities in India increase the number of engineering graduates Increasing the number of engineering graduates increases India’s human capital Both the short-run and long-run aggregate supply increases, as shown in Figure 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 10.1 by the rightward shifts in the short-run and long-run aggregate supply curves • The money wage rate rises An increase in the money wage rate increases firms’ costs Short-run aggregate supply decreases but long-run aggregate supply does not change Long-run aggregate supply does not change because in the long run the price level rises by the same percentage the money age rate increased, so in the long run employment does not change This situation is illustrated in Figure 10.2, in which the short-run aggregate supply curve shifts leftward and the long-run aggregate supply curve does not change • The price level in India increases In the short run, an increase in the price level increases the quantity of real GDP supplied In the long run, the money wage rate rises by the same percentage so in the long run there is no change in the quantity of real GDP supplied These results are illustrated in Figure 10.3 by the grey arrows showing the movement along the short-run aggregate supply curve, SAS, and the movement along the long-run aggregate supply curve, LAS Labor productivity is rising at a rapid rate in China and wages are rising at a similar rate Explain how a rise in labor productivity and wages in China will influence the quantity of real GDP supplied and aggregate supply in China The rise in labor productivity increases potential GDP and increases aggregate supply The short-run and long-run aggregate supply curves shift rightward The rise in the money wage rate in China decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward It has no effect on potential GDP or on the long-run aggregate supply curve Canada trades with the United States Explain the effect of each of the following events on Canada’s aggregate demand • The government of Canada cuts income taxes Cutting income taxes increases aggregate demand because it increases people’s disposable incomes • The United States experiences strong economic growth Strong growth in the United States increases U.S demand for Canadian exports Canadian exports are a component of Canada’s aggregate demand so the increase in demand for Canada’s exports means that Canada’s aggregate demand increases 127 128 • CHAPTER 10 Canada sets new environmental standards that require power utilities to upgrade their production facilities To upgrade their facilities, power utilities must increase their investment Investment is a component of aggregate demand so an increase in investment means that Canada’s aggregate demand increases The Fed cuts the quantity of money and all other things remain the same Explain the effect of the cut in the quantity of money on aggregate demand in the short run A decrease in the quantity of money decreases aggregate demand and shifts the AD curve leftward By cutting the quantity of money, the interest rate rises, so firms decrease their investment and households cut back their expenditure on new homes, new cars, and other big-ticket items The decrease in consumption expenditure and investment both decrease aggregate demand Gross Domestic Product for the Second Quarter of 2012 The increase in real GDP in the second quarter primarily reflected increases in personal consumption expenditures, exports, and investment Government spending decreased Source: Bureau of Economic Analysis, August 29, 2012 Explain how the items in the news clip influence U.S aggregate demand The increase in consumption expenditures, exports, and investment all increase U.S aggregate demand The decrease in government spending decreases U.S aggregate demand Use Figure 10.4 to work Problems to Initially, the short-run aggregate supply curve is SAS0 and the aggregate demand curve is AD0 Some events change aggregate demand from AD0 to AD1 Describe two events that could have created this change in aggregate demand What is the equilibrium after aggregate demand changed? If potential GDP is $1 trillion, the economy is at what the type of macroeconomic equilibrium? Aggregate demand increases when the aggregate demand curve shifts from AD0 to AD1 Aggregate demand increases if expected future income, expected future inflation, or expected future profit increases; if the government cuts taxes, increases its expenditure on goods and services, or increases its transfer payments; if the Fed lowers the interest rate; or if the U.S exchange rate falls or foreign income increases After the change in aggregate demand, equilibrium is at point C: real GDP is $1.1 trillion and the price level is 105 The economy is at an above full-employment equilibrium with an inflationary gap 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 Some events change aggregate supply from SAS0 to SAS1 Describe two events that could have created this change in aggregate supply What is the equilibrium after aggregate supply changed? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no output gap? Aggregate supply decreases when the aggregate supply curve shifts from SAS to SAS Aggregate supply decreases if potential GDP decreases; if the money wage rate rises; or if the money prices of other resources rise After the change, equilibrium is at point A: real GDP is $0.9 trillion and the price level is 105 The economy is at a below full-employment equilibrium with a recessionary gap Some events change aggregate demand from AD0 to AD1 and aggregate supply from SAS0 to SAS1 What is the new macroeconomic equilibrium? After the changes, equilibrium is at point D: real GDP is $1.0 trillion and the price level is 110 The economy is at a full-employment equilibrium Describe the policy change that a classical macroeconomist, a Keynesian, and a monetarist would recommend for U.S policymakers to adopt in response to each of the following events: a Growth in the world economy slows Classical economists probably would recommend no policy action If they suggested any policy at all, the policy would involve cutting taxes Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate Keynesian economists likely would suggest several policies, such as the U.S government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates b The world price of oil rises Classical and monetarist economists probably would recommend no policy action If they suggested any policy at all, the policy would involve cutting taxes Keynesian economists likely would suggest several policies, such as the U.S government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates c U.S labor productivity declines Classical economists probably would recommend no policy action If they suggested any policy at all, the policy would involve cutting taxes Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate Keynesian economists likely would suggest several policies, such as the U.S government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates 129 130 CHAPTER 10 Answers to Additional Problems and Applications 10 Explain for each event whether it changes the quantity of real GDP supplied, short-run aggregate supply, long-run aggregate supply, or a combination of them • Hong Kong firms switch to lower-cost 3D printing technology New technology raises productivity, which increases both short-run and long-run aggregate supply • An ageing population is expected to shrink Hong Kong’s labor force Shrinking labor force decreases short-run and long-run aggregate supply • Foreign students in Hong Kong universities get temporary work permits • Firms from mainland China open offices in Hong Kong Increase in labor force increases short-run and long-run aggregate supply • An increase in the quantity of capital increases short-run and long-run aggregate supply The Hong Kong price level rises A rise in the price level might result from an increase in aggregate demand, which causes an increase in the quantity of real GDP supplied, or from a decrease in short-run aggregate supply, which causes a decrease in the quantity of real GDP demanded 11 Examine for each event whether it changes the quantity of real GDP demanded or aggregate demand in Japan • Japanese price level rises • A rise in the Japanese price level leads to a decrease in the quantity of real GDP demanded Depreciation of yen attracts more tourists to Japan Exports of services increase which increases aggregate demand • Japan’s coal consumption rises due to a prolonged shut down of nuclear plants The increase in consumption expenditure increases aggregate demand • Japan’s sales tax rises Higher sales tax lowers consumption expenditure, which decreases aggregate demand 12 Changes in Inventory Investment When real GDP increased in the first quarter of 2015, personal consumption expenditure, private inventory investment, and imports increased while exports, nonresidential fixed investment, and government spending decreased Source: Bureau of Economic Analysis, April 29, 2015 Explain how the increase in private inventory investment affected U.S aggregate demand Private inventory investment is the change in value of firms’ stocks of unfinished or finished but unsold goods It is a type of investment expenditure The increase in inventory investment increased aggregate demand 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 13 Exports and Imports Increase Real exports of goods and services increased 6.0 percent in the second quarter, compared with an increase of 4.4 percent in the first Real imports of goods and services increased 2.9 percent, compared with an increase of 3.1 percent Source: Bureau of Economic Analysis, August 29, 2012 Explain how the changes in exports and imports reported here influence the quantity of real GDP demanded and aggregate demand In which of the two quarters reported did exports and imports make the greater contribution to aggregate demand growth? Net exports is part of aggregate demand, which means that an increase in net exports increases aggregate demand Net exports equals exports minus imports, so an increase in exports increases aggregate demand while an increase in imports decreases aggregate demand In both quarters, exports increased so in both quarters exports increased aggregate demand In both quarters, imports increased, so in both quarters imports decreased aggregate demand The biggest contribution to economic growth was in the second quarter, because export growth rose significantly from 4.4 percent to 6.0 percent while import growth fell, from 3.1 percent to 2.9 percent Use the following information to work Problems 14 to 16 According to the East Asia and Pacific Economic Update published by the World Bank in April 2015, the following factors have affected China’s real GDP in 2015 • Global economic recovery supports a moderate increase in China’s exports • China benefits from a fall in the world price of oil • Chinese government to cut excess capacity in heavy industry • U.S firms to relocate their labor-intensive manufacturing industries to lowcost countries 14 Explain how each of the above factors changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them The global economic recovery increases China’s exports, which increases aggregate demand As the world price of oil is prone to fluctuations in the long run, a fall in the world price of oil leads to an increase in short-run aggregate supply The cut back in the excess capacity of production in heavy industry does not change short-run aggregate supply and long-run aggregate supply As the excess capacity is reduced, the expected returns to new investment (in capacity) increase, leading to an increase in aggregate demand The relocation of labor-intensive manufacturing industries from the U.S to low-cost countries such as China increases production, increasing both the short-run aggregate supply and the longrun aggregate supply 15 Explain how each factor separately affect China’s real GDP and the price level, starting from a position of long-run equilibrium The increase in China’s exports raises the price level and increases real GDP The fall in the world price of oil increases short-run aggregate supply, which decreases the price level and real GDP The reduction in excess capacity of production in heavy industry does not change short-run aggregate supply and long-run aggregate supply Due to an increase in expected returns from new investment, aggregate demand increases, which raises the price level and increases real GDP The relocation of labor-intensive manufacturing industries to China increases 131 132 CHAPTER 10 short-run aggregate supply and long-run aggregate supply, which decreases the price level and increases real GDP 16 Explain the combined effects of these factors on China’s real GDP and the price level, starting from a position of long-run equilibrium The combined effect is that real GDP increases but the effect on the price level is uncertain All factors (except global economic recovery which increases China’s exports) lower the price level The increase in China’s exports raises 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 Use the following information to work Problems 17 and 18 In Japan, potential GDP is 600 trillion Real GDP Real GDP supplied yen The table shows the aggregate demanded in the short run demand and short-run aggregate Price (trillions of 2005 yen) supply schedules level 17.a Draw a graph of the 75 600 400 aggregate demand curve and 85 550 450 the short-run aggregate 95 500 500 supply curve 105 450 550 Figure 10.5 shows the 115 400 600 aggregate demand curve and 125 350 650 the short-run aggregate supply 135 300 700 curve b What is the short-run equilibrium real GDP and price level? Equilibrium real GDP is ¥500 trillion and the price level is 95 Short-run macroeconomic equilibrium occurs at the intersection of the aggregate demand curve and the short-run aggregate supply curve 18 Does Japan have an inflationary gap or a recessionary gap and what is its magnitude? Equilibrium real GDP is less than potential GDP, so Japan has a recessionary gap The recessionary gap equals the difference between potential GDP and real GDP, which is ¥100 trillion Use the following information to work Problems 19 and 20 Spending by Women Jumps The magazine Women of China reported that Chinese women in big cities spent 63% of their income on consumer goods last year, up from 26% in 2007 Clothing accounted for the biggest chunk of that spending, at nearly 30%, followed by digital products such as cellphones (11%) and travel (10%) Chinese consumption as a whole grew faster than the overall economy and is expected to reach 42% of GDP by 2020, up from the current 36% Source: The Wall Street Journal, August 27, 2010 19 Explain the effect of a rise in consumption expenditure on real GDP and the price level in the short run Figure 10.6 (on the next page) shows the effect from the increase in consumption expenditure Consumption expenditure is one of the components of aggregate demand, so an increase in consumption expenditure increases aggregate demand 133 134 CHAPTER 10 and shifts the aggregate demand curve rightward In the figure the aggregate demand curve shifts from AD0 to AD1 Because aggregate demand increased, equilibrium real GDP increases (in Figure 10.6 from 33.0 trillion yuan to 33.2 trillion yuan) and the price level rises (in the figure from 117 to 119) 20 If the economy had been operating at a full-employment equilibrium, a Describe the macroeconomic equilibrium after the rise in consumer spending If the economy had been operating at a full-employment equilibrium before the increase in consumer expenditure, after the increase equilibrium real GDP exceeds potential GDP The economy is at an above full-employment equilibrium with an inflationary gap b Explain and draw a graph to illustrate how the economy can adjust in the long run to restore a full-employment equilibrium Figure 10.7 shows how the economy can adjust to its long-run equilibrium In the short run, real GDP exceeds potential GDP Employment exceeds full employment The tight labor market means that the money wage rate starts to rise As the money wage rate rises short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward Real GDP and employment decrease Even though employment is decreasing, as long as employment exceeds full employment, the money wage rate continues to rise and the short-run aggregate supply continues to decrease The process ultimately ends when real GDP has decreased back to equal potential GDP and employment equals full employment Short-run aggregate supply has decreased and the short-run aggregate supply curve has shifted from SAS to SAS1 At this point the price level has risen (to 121 in Figure 10.7) and real GDP has returned to potential GDP (33.0 trillion yuan) 21 Suppose that the E.U economy goes into an expansion Explain the effect of the expansion on U.S real GDP and unemployment in the short run When the E.U economy moves into an expansion, U.S exports to the E.U increase The increase in U.S exports increases U.S aggregate demand, thereby increasing U.S real GDP and lowering U.S unemployment 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 22 Explain why changes in consumer spending and business investment play a large role in the business cycle Changes in consumer spending play a large role in business cycles because consumption expenditure is by far the largest part of GDP A small percentage change in consumption expenditure is a large change in aggregate demand which can lead to a large change in real GDP Changes in investment spending are also important because investment spending is quite volatile and subject to large changes Consequently a decrease in investment often leads to a large decrease in aggregate demand and a recession while an increase frequently results in a large increase in aggregate demand and an expansion 23 How to Avoid Recession? Let the Fed Do Its Work Greg Mankiw wrote in 2007 on the eve of the Global Financial Crisis, “Congress made its most important contribution to taming the business cycle back in 1913, when it created the Federal Reserve System Today, the Fed remains the first line of defense against recession.” Source: The New York Times, December 23, 2007 a Describe the process by which action by the Fed in times of recession flows through the economy An increase in the quantity of money lowers interest rates and makes it easier to get a loan The lower interest rate leads businesses to increase their investment and households to increase spending on new homes and other consumer durables Banks, eager to lend, lower their lending standards and more people and firms qualify for loans All these effects increase aggregate demand and thereby raise real GDP b Draw a graph to illustrate the Fed’s action and its effect Figure 10.8 shows how the Fed’s action increases aggregate demand, shifting the aggregate demand curve rightward from AD0 to AD1 Real GDP increases from $16.0 trillion to $16.2 trillion 24 Cut Taxes and Boost Spending? Raise Taxes and Cut Spending? Cut Taxes and Cut Spending This headline expresses three views about what to to get the U.S economy growing more rapidly and contribute to closing a large recessionary gap Economists from which macroeconomic school of thought would recommend pursuing policies described by each of these views? The first policy, cut taxes and boost spending, would be endorsed by the Keynesian and new Keynesian schools The second policy, raise taxes and cut spending, is endorsed by no school of thought The third policy, cut taxes and cut spending, would be endorsed by the classical and new classical schools 135 136 CHAPTER 10 Economics in the News 25 After you have studied Economics in the News on pp 296–297 (704–705 in Economics), answer the following questions a What are the main features of the U.S economy in the second quarter of 2014? The main feature of the U.S economy in the second quarter of 2014 was rapid growth The economy grew at a faster than average rate of 4.2 percent in that quarter The growth rate was significantly more rapid than in the first quarter when the U.S economy grew at only 2.1 percent b Did the United States have a recessionary gap or an inflationary gap in 2014? How you know? The U.S economy had a recessionary gap Unemployment was high and actual GDP was below potential GDP c Use the AS-AD model to show the changes in aggregate demand and aggregate supply that occurred in 2013 and 2014 that brought the economy to its situation in mid-2014 Figure 10.9 shows the changes between 2013 and 2014 There was a recessionary gap so in the figure the aggregate demand curve, AD13, and the short-run aggregate supply curve, SAS 13, intersect to the left of the long-run aggregate supply curve, LAS13 Potential GDP was $16.5 trillion in 2013 and actual real GDP was only $15.6 trillion The economy had a large recessionary gap though it would shrink in 2014 In 2013 and 2014 fiscal and monetary policy as well as an expanding world economy increased aggregate demand Short-run aggregate supply did not change because the increase in potential GDP (which increases short-run aggregate supply) was small and probably offset by a higher money wage rate (which decreases short-run aggregate supply) The aggregate demand curve shifted rightward, to AD14 in Figure 10.9 The economy remained below full employment because the long-run aggregate supply curve had shifted rightward to LAS14 Real GDP was $16.0 trillion but potential GDP was $16.7 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 d Use the AS-AD model to show the changes in aggregate demand and aggregate supply that will have occurred when full employment is restored Figure 10.10 shows this result In it the aggregate demand curve has shifted rightward from AD14 to ADpolicy Equilibrium real GDP is $16.7 trillion, the same as potential GDP The price level has risen, from 108 to a little less than 112 137 138 CHAPTER 10 e Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the federal government increased its expenditure on goods and services or cut taxes by enough to restore full employment Fiscal policy of increasing government expenditure on goods and services or cutting taxes increases aggregate demand and shifts the aggregate demand curve rightward Figure 10.10 shows this policy In it the aggregate demand curve has shifted rightward from AD14 to ADpolicy Equilibrium real GDP is $16.7 trillion, the same as potential GDP The price level has risen, from 108 to 112 f Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the economy moved into an inflationary gap Show the short-run and the long-run effects If government policy leads to an inflationary gap, the aggregate demand curve will have shifted rightward so that it intersects the short-run aggregate supply curve at a point to the right of potential GDP In Figure 10.11, the government policy would shift the aggregate demand curve to AD The price level is 112.5 and equilibrium real GDP is $16.9 trillion while potential GDP is only $16.7 trillion The economy has an inflationary gap In the long run, the inflationary gap will be eliminated For simplicity, presuming that neither potential GDP nor aggregate demand increase, the tight labor market will lead to increases in the money wage rate As the money wage rate rises, firms’ costs increase The short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward Eventually aggregate supply decreases so that the short-run aggregate supply curve has shifted to SAS in Figure 10.11 At that moment, the economy is back to full employment: Equilibrium real GDP, $16.7 trillion, equals potential GDP, also $16.7 trillion The price level, of course, has risen, in the figure from 112.5 to 114.0 26 Brazil Falls into Recession A decade ago, Brazil had rapid growth but now its economy is experiencing a slowdown with investment falling, and inventories increasing Potential GDP growth rate has slowed Business and consumer confidence has fallen Source: BBC News, August 29, 2014 a Explain the effect of a decrease in investment on real GDP and potential GDP The first effect of a decrease in investment is a decrease in aggregate demand The decrease in aggregate demand decreases real GDP As investment remains depressed, the capital stock grows more slowly, which decreases the growth rate of potential GDP 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 b Explain how business and consumer confidence influences aggregate expenditure The decrease in business confidence leads businesses to decrease their investment The decrease in investment decreases the Brazil’s aggregate expenditure Similarly, the decrease in consumer confidence lowers consumer expenditure, thereby again decreasing Brazil’s aggregate expenditure 139 ... AD14 to ADpolicy Equilibrium real GDP is $16.7 trillion, the same as potential GDP The price level has risen, from 108 to a little less than 112 137 138 CHAPTER 10 e Use the AS-AD model to show... Explain and draw a graph to illustrate how the economy can adjust in the long run to restore a full-employment equilibrium Figure 10. 7 shows how the economy can adjust to its long-run equilibrium... from SAS to SAS1 At this point the price level has risen (to 121 in Figure 10. 7) and real GDP has returned to potential GDP (33.0 trillion yuan) 21 Suppose that the E.U economy goes into an expansion
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