Problem Set # 14. Instructions: Graph 1,

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1 Problem Set # 14 Aggregate Demand and Aggregate Supply in the Real World Overview: In this problem set, you will apply what you know about Aggregate Demand and Aggregate Supply to real world data. In a series of two graphs, you will plot the condition of the U.S. economy at different periods of time. You will analyze changes which occurred in terms of the Aggregate Demand and Short-Run Aggregate Supply model. Note: In chapter 10, we concentrated on changes in the money supply as shifters of AD. When doing this assignment, you should broaden your (AD) scope. i.e. Remember that other things can shift AD. Any change in real spending (for example, an autonomous change in investment spending) will shift AD. Graph 1: Instructions: Graph 1, * Use Price on Your Vertical Axis * a. On a sheet of graph paper or spreadsheet printout, neatly plot the Price Level (vertical axis) and Real GDP (horizontal axis) for each year from 1929 to to 15 is a good range for price level axis. $400 B to $900 B is a good range for the Real GDP axis. Label each point with the year. The data for this can be found on page 2. b. Draw AD and SRAS curves through your points. Clearly label each curve with its year. Make sure that your AD and SRAS SRAS curves have the same slope. Make sure that no AD curve crosses any other AD curve. Make sure that no SRAS curve crosses any other SRAS curve. You can use the same AD curve for more than one point if the points will easily fit on the same AD curve. Likewise, you may use the same SRAS curve for more than one point if the points will easily fit on the same SRAS curve. c. Summarize the major economic events of the period. Was there a typical recession (falling output accompanied by downward price pressure) followed by a recovery? Was there a period of stagflation (falling output combined with upward price pressure)? Was there a long period of economic growth? This should be neatly typed on a separate sheet of paper. d. Analyze your data in the context of AD and SRAS. For example, if there was a recession, was its major cause a change in AD? Or, did a change in SRAS cause the downturn? As another example, if there was an expansion/recovery, was is it caused by changes in SRAS or in AD or both? In short, tell me how the shifts of the curves caused the economic outcomes of the time. Then, based on data given in this handout (or from class, the text, etc.) speculate as the causes of the shifts in AD 1

2 or SRAS. Make your speculation as intelligent and fact based as possible. This, along with your answers to 1c, should be neatly typed on a separate sheet of paper. Finally, tell me how quickly the economy seems to have been adapting to the long-run. Was SRAS shifting rapidly (enough to offset changes in AD) or slowly (too slow to offset any changes in AD)? The Data: Year Price Level Real GDP M1 Real G Real I Real Taxes Real 92 GDP Deflator Billions of 92 $'s Billions of $'s Billions of 92 $'s Billions of 92 $'s Billions of 92 $'s Net Priv. Debt Year $ $ $ $ $ $ $ $ $ $ $ $ Instructions: Graph 2 * Use the Modified AD-SRAS Model * Notes on Inflation Expectations and the Modified AD-SRAS Model: Believe it or not, the Great Depression is relatively easy to analyze within the AD-SRAS model. The reason is that there is less reason to worry about the effect of inflation expectations on the year to year shifts of AD and SRAS. Simply put, prior to 1929, the economy had not seen long periods of continuous inflation. Expected inflation (according to adaptive expectations theory) can be assumed to have been about 0%. This is no longer true once we move into the time periods examined in graphs 2, 3, and 4. During these time periods, the 70, 80 s, and 90 s, people in the economy came to expect a certain inflation rate. According to adaptive expectations theory, they would base their inflation expectations on inflation rates from years recently past. This would cause both AD and SRAS to shift up, automatically, by the expected inflation rate even if nothing else changed. 2

3 For example, assume that buyers, sellers, workers, heck everybody, expects 2% inflation. Each year, buyers would be willing to pay 2% more for the same goods and services as before. This will cause AD to shift up automatically. Wages and other costs will also have to increase by 2% a year just to keep workers (and other resource owners) up with expected inflation. i.e. If firms want workers to work the same amount, firms will have to automatically raise their wages 2% a year. Because of their (2% a year) increase in costs, year, sellers would only be willing to produce the same amount if they receive 2% more for it. SRAS will therefore automatically shift up by 2% a year. In figure 1a this economy is graphed according to the conventional AD-SRAS model. Yowsa! A new AD and SRAS curve have to be drawn each year even though there is no major changes in the economy. Since the economy has been experiencing 2% inflation and everyone expects 2% inflation in the near future, both AD and SRAS shift upwards by 2% a year. Hmmm lot of work just to depict an economy that is doing everything the same (including the 2% inflation rate) as it has done in the past. Figure 1: Two ways of depicting the same thing: An economy with no growth of real GDP and no change in the inflation rate. Figure 1a ( ) Figure 1b ( ) P rising price + 1 % & AD % inflation as expected SRAS 2 AD 2 inflation rate from previous year 0% & SRAS 2 E 1 & E E 1-1 % falling price Instead of using a standard AD-SRAS model for charts 2 4, you will use a modified AD-SRAS model. The modified AD-SRAS model has the Change in the Inflation Rate on its vertical axis, not the price level. In figure 2b the economy just described (i.e. expecting 2% inflation) is graphed according the modified AD-SRAS model. A lot simpler, huh? Things get even more complex when the inflation rate changes. Consider our economy which has been expecting 2% inflation. Both AD and SRAS will shift up by 2% a year ceteris paribus. 3

4 Assume, however, that government spending increases greatly and AD increases faster than 2%, say 4%. In the normal (i.e. Price on the vertical axis) AD-SRAS model, things are a bit hairy. This is shown in figure 2a (next page). The modified AD-SRAS model handles this faster than expected growth of AD in a simpler manner as shown in. Figure 2b (below). Figure 2: Two ways of depicting the same thing: An economy expecting 2% inflation but in which AD grows faster than expected. Figure 2a ( ) Figure 2b ( ) P rising price % expected SRAS 2 AD 2Expected E 1 AD 2Actual inflation rate from previous year 0% falling price & SRAS 2 E 1 AD 2 The second reason for using the modified model is that it more directly addresses our concern as economists. We tend to ask; What causes an increase in inflation?, not What causes a 12% inflation rate? or What causes a price level of 162?. Likewise, good economists ask; How can an economy reduce inflation? rather than How can an economy achieve a 10% inflation rate? Okay back to your regular programming. Graph 2: a. On a sheet of graph paper or spreadsheet printout, neatly plot the change in the inflation rate and real GDP for each year from 1970 to % to +5% is a good range for the change in the inflation rate axis. $3,200 B to $4,200 B is a good range for the Real GDP axis. Label each point with the year. The data for this can be found on page 6. 4

5 b. Draw AD & SRAS curves through your points. Clearly label each curve with its year. Follow the same instructions as in Graph 1 b. c. What were the major economic events of the period examined? Follow the same instructions as in Graph 1 c. d. Analyze your data in the context of AD & SRAS. Follow the same instructions as in Graph 1d. The Data: Year GDP PI ('92 = 100) Inflation Inflation Real '92 GDP (Billions) % 0.8% $ 3, % -0.3% $ 3, % -1.2% $ 3, % 1.6% $ 3, % 3.4% $ 3, % 0.3% $ 3, % -3.4% $ 4, % 0.3% $ 4, % 1.1% $ 4, % 1.1% $ 4, % 0.8% $ 4, % 0.2% $ 4, % -3.1% $ 4, % -2.1% $ 4, % -0.6% $ 5, % -0.3% $ 5, % -0.8% $ 5, % 0.4% $ 5, % 0.5% $ 5, % 0.6% $ 6, % 0.2% $ 6, % -0.4% $ 6, % -1.2% $ 6, % -0.2% $ 6, % -0.2% $ 6, % -0.2% $ 6, % -0.4% $ 6,