ECON 102: Macroeconomics HW 8 Solution

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1 ECON 102: Macroeconomics HW 8 Solution Adibah Abdulhadi Taehoon Kim Cici McNamara Steven Zhang March 7, HW8: Chapter 12 Problems: 1, 4, 6, 8, 10, 11, 12, 14, 15 A fall in the value of the dollar against other currencies makes U.S. final goods and services cheaper to foreigners but does not affect the domestic aggregate price level. Consequently, at every aggregate price level, aggregate output is higher from a domestic perspective due to the increase in demand from foreigners for U.S. exports. This manifests itself in a rightward shift in the aggregate demand curve rather than a movement along the curve, so you are correct and your study partner is wrong In the short run, the rise in the aggregate price level extends to everything except wages. This will increase firm s profits, and aggregate output will increase from Y1 to Y2. However, in the long run, wages will rise as well, so the firm s costs will increase, reducing profits and shifting the LRAS curve to the left back to long-run equilibrium at the reduced level of output. 1

2 12.6 Ranked in order from most to least preferred: 1. positive supply shock: increases output while decreasing prices so that the shock causes neither inflation nor unemployment. 2. positive demand shock: increases output while raising prices, causing inflation but not unemployment. The consequences of the shock can be addressed through either fiscal policy in the form of reduced spending or raised taxes or through monetary policy policy in the form of a reduced money supply. 3. negative demand shock: decreases output while lowering prices, causing unemployment but not inflation. The consequences of the shock can be addressed through either fiscal policy in the form of increased spending or tax cuts or through monetary policy in the form of an increase in the money supply. 4. negative supply shock: reduces output while raising prices so that the shock causes both inflation and unemployment. The use of monetary or fiscal policy to shift the demand curve and address inflation will worsen unempoyment and vice versa. 2

3 12.8 The introduction of the computer operating system increases labor productivity and shifts the SRAS curve to the right. This will transition the economy from one short-run equilibrium to another with a higher level of aggregate output and lower aggregate price level. 3

4 a b An increase in the oil price is a negative supply shock: SRAS shifts to the left. 4

5 12.10.c A drop in home prices is a negative demand shock: AD shifts to the left d Both shocks reduced demand so that Y3 is unquestionably lower than Y1. However, the supply shock raised the aggregate price level while the demand shock lowered it, so the total effect on the aggregate price level is indeterminate wihtout knowing the relative sizes of the shocks a A decrease in households wealth will result in a negative demand shock, shifting the aggregate demand curve to the left, decreasing the aggregate price level and aggregate output. In the short run, there will be a recessionary gap. In the long run, wages will be renegotiated and lowered to account for the lower aggregate price level, lowering firm s costs and inducing a positve supply shock. This will shift the SRAS curve rightward so that it intersects aggregate demand and the LRAS curve, bringing us back to equilibrium at the same level of aggregate output but a lower aggregate price level. 5

6 12.11.b A tax cut will result in a positive demand shock, shifting the aggregate demand curve to the right, increasing the aggregate price level and aggregate output. In the short run, there will be an inflationary gap. In the long run, wages will be renegotiated to account for the higher aggregate price level, raising firm s costs and inducing a negative supply shock. This will shift the SRAS curve leftward so that it intersects aggregate demand and the LRAS curve, bringing us back to equilibrium at the same level of aggregate output but a higher aggregate price level. 6

7 a A tax increase will result in a negative demand shock, shifting the aggregate demand curve to the left, decreasing the aggregate price level and aggregate output. In the short run, there will be an recessionary gap. In the long run, wages will be renegotiated to account for the lower aggregate price level, lowering firm s costs and inducing a positive supply shock. This will shift the SRAS curve rightward so that it intersects aggregate demand and the LRAS curve, bringing us back to equilibrium at the same level of aggregate output but a lower aggregate price level. 7

8 12.12.b An increase in the money supply will result in a positive demand shock, shifting the aggregate demand curve to the right, increasing the aggregate price level and aggregate output. In the short run, there will be an inflationary gap. In the long run, wages will be renegotiated to account for the higher aggregate price level, raising firm s costs and inducing a negative supply shock. This will shift the SRAS curve leftward so that it intersects aggregate demand and the LRAS curve, bringing us back to equilibrium at the same level of aggregate output but a higher aggregate price level. 8

9 a The aggregate price level rose while aggregate output fell. This is known as stagflation b To address the fall in aggregate output, the government could use either fiscal or monetary policy to induce a positive aggregate demand shock. This could be accomplished with monetary policy by increasing the money supply or with fiscal policy by either cutting taxes or increasing government spending. While these polices address the fall in output, they exacerbate inflation even further. 9

10 To address the rise in aggregate prices the government could use either fiscal or monetary policy to induce a negative aggregate demand shock. This could be accomplished with monetary policy by decreasing the money supply or with fiscal policy by either raising taxes or decreasing government spending. While these polices address the rise in prices, they exacerbate the fall in output even further. 10

11 12.14.c Supply shocks represent a dilemma for government policy makers because they cause aggregate output and prices to increase or decrease together. Because policy makers have little power to shift the SRAS curve, their only tool in affecting equilibrium is by shifting the aggregate demand curve, which can only address one economic malady at the expense of the other Increases in aggregate output accompanied by little or no changes in aggregate prices indicate rightward shifts of the SRAS, aggregate demand, and LRAS curves. Increases in worker productivity in the 1990s would have shifted both the SRAS and LRAS curves to the right. Additionally, a strong stock market would have increased household wealth and shifted the aggregate demand curve to the right as well. 11