Economics 102 Homework #7 Due: December 7 th at the beginning of class

Transcription

1 Economics 102 Homework #7 Due: December 7 th at the beginning of class Complete all of the problems. Please do not write your answers on this sheet. Show all of your work. 1. The economy starts in long run equilibrium. a. Sketch the initial AS/AD graph and the initial aggregate expenditure graph. Be sure to carefully label everything. Price LRAS Planned Expenditures SRAS 45 APE P 1 PE 1 AD Here are the initial graphs of both AD/AS and aggregate expenditures. On these two graphs, the x-axis is the same, so should be the same in both graphs. Also the equilibrium expenditures occur where the APE curve crosses the 45 line. This is point where planned expenditures equal actual expenditures, so PE 1 equals. b. Due to a potential downturn in the economy, Investment spending falls. Show the effect of this change on an aggregate expenditure graph. Specifically discuss the change in Real GDP and the change in planned expenditures. Planned Expenditure 45 APE1 PE 1 APE 2 PE 2 Q 2

2 Since aggregate planned expenditures is comprised of Government, Investment and Consumption, so if investment falls the APE curve will shift down by exactly the amount that I decreased. The new equilibrium point will be where APE 2 crosses the 45 line. At that point, both planned and actual expenditures will be lower, since actual expenditures is equal to real GDP, real GDP will be lower as well. c. Independently from part b, assume investment falls. Show the short run effects of this change on an AS/AD graph? Price level LRAS SRAS P 1 P 2 AD 2 AD 1 Q 3 This change is the same as we have seen many times in this class. Output falls, price level falls, unemployment rises, nominal wages don t change and real wages rise. d. Show how the short run affects in part c effect the aggregate expenditure graph. Planned Expenditure 45 APE1 PE 1 PE 3 APE3 APE 2 PE 2 Q 2 Q 3 In part c the price level has fallen. The APE curve is for a given price level. As a result when the price level changes the APE curve must shift as well. In this case the price level has fallen, which means that for a given level of income (Y) individuals

3 will plan on purchasing more goods. This will shift the APE curve up to APE3. The level of output, Q3, is the same level on both the graph in part c and in part d. e. Explain using both words and graphs the long run changes on the AS/AD graph. Price level LRAS SRAS 1 SRAS 2 P 1,2 P 3 P 4 AD 2 AD 1 Q 3,4 This part is also very familiar from earlier in the class. In the long run because unemployment is high there is competition among workers for jobs. This will push wages lower and lower wages mean a lower cost of production, so the SRAS curve wi ll shift to the right to SRAS 2. This will put the economy back in long run equilibrium with the same level of output, the same level of unemployment, but a much lower price level. f. Show the long run effects on the aggregate expenditure graph. Planned Expenditure 45 APE1,4 PE 1,4 PE 3 APE3 APE 2 PE 2 Q 2 Q 3,4 The further decrease in the price level in part e, causes the APE curve to shift up again, to APE 4 ( Which is the same as APE 1 ). The shift must push the economy back to the same

4 level of output as it started. This is because the quantity values on the graphs in parts e and f should line up. 2. You know the following information about the economy of the fictional country Ameriland. Y C I G a. Carefully graph the aggregate expenditure (AE) curve for this economy. (It may be helpful to use Excel.) Aggregate Planned Expenditures APE Since APE is equal to C + I + G, we get the APE curve simply by adding C, I and G from the above table and then plotting them against Y. b. Write down the equation for the aggregate expenditure curve and the marginal propensity to consume. Explain what the marginal propensity to consume means. In order to find the equation for the APE curve, we need two things, the slope and the intercept. We can find the slope easily enough by looking at how much APE changes when Y changes, slope = ΔAPE/ΔY. When Y increases by, APE increases by 60, therefore the slope = 60/ = 3/5 = 0.6. So if Y decreased from to zero, APE must decrease by 60. Thus the intercept is 160. So combining these we get the equation for APE: APE = 0.60Y

5 Since the slope is equal to the marginal propensity to consume (MPC), MPC is equal to This means that for every $1 of additional income received, 60% of that dollar will be spent, and the remaining 40% will be saved. c. Indicate on your graph the equilibrium expenditure level. How do you know this is the equilibrium level? Aggregate Planned Expenditures APE The black dot indicates the equilibrium point. We know it is the equilibrium, because if planned and actual expenditures were different then plans would change. The only point where there would be no additional changes is the point where actual equals planned; which is also the point where the APE curve crosses the 45 line. d. If Y=200, what is happening to inventories (actual and planned)? What does this imply for GDP? If Y is 200, then we are below the equilibrium level of the graph above. This means that planned expenditures are higher than actual expenditures. Since the only reason that planned can be different from actual comes from inventories, it must be that planned inventories are higher than actual inventories. If a firm has a lower inventory level than they planned on having then in the future they will increase production in order to bring there inventory levels up to the level they want. An increase in production will cause there to be an increase in Y which will move us to a higher level of real GDP on the graph. This adjustment will continue until the graph is in equilibrium.

6 e. Assume this economy is initially in long-run equilibrium, you have the following aggregate demand schedule and the short run aggregate supply curve has a slope of 0.05: Y Price Level Carefully draw the AD/AS graph for this economy. Note your graph should contain 3 curves, AD, SRAS, and LRAS. AS / AD LRAS SRAS AD From the APE graph above, we know the equilibrium level of Y is 400. Since the economy is in equilibrium at that level of Y, then the LRAS curve must be equal to 400. This also means that SRAS and AD must cross when Y equals 400. f. Draw two new graphs that show the impact of an increase of 80 in G on both the AE graph and the AD/AS graph. Your AE graph should contain both the initial AE curve and the new AE curve. Your AD/AS graph should contain two AD curves. Be sure to label the new equilibrium level of expenditures.

7 Aggregate Planned Expenditures APE 2 APE Since APE is equal to C + I + G, an increase in G will shift the APE curve straight up by 80. This brings us to a new equilibrium level of Y of 600. g. What is the value of the multiplier in this economy? What does this multiplier mean? There are two ways that we can figure out the multiplier. The first is from the formula we derived in class: multiplier = 1/(1 MPC) = 1/(1 0.60) = 1/0.4) = 2.5. The other way that we can figure out the multiplier is to remember what the multiplier means. The multiplier tells us how much Y increases when G or I increase; in symbols the multiplier is ΔY/ΔG. Since we increased G by 80 and equilibrium Y increased by 200, the multiplier = 200/80 = 2.5. Therefore the multiplier tells us that when we increase G or I by $1, Y increases by $2.50. h. What is the new equilibrium GDP in your AS/AD model? Carefully explain why this is different from the equilibrium level of expenditures. The shift in G will also affect the AS/AD graph. The x-axis of the AS/AD is Y, so the reason that AD will change is because of the effect the increase in G has on Y. In this case with a multiplier of 2.5, the increase in G of 80 will increase Y by 200. Thus we need to shift the AD curve to the right by 200. (Note the AD curve does not shift up, it shifts to the right).

8 AS / AD LRAS SRAS AD 2 AD1 The graph above shows a rightward shift of AD by 200. The new equilibrium level of Y is 500. Note this is different than the equilibrium level that we got in our APE graph above; there the equilibrium level of Y was 600. The reason for the difference is that the APE curve is for a given price level and the AS/AD model allows for changes in the price level. So when the price level rises in this graph from to 105 it would cause the APE curve to shift down (For a given level of income higher prices mean everyone will buy less). The downward shift of APE would move the equilibrium in that graph to the point where Y is equal to 500 as well. i. Show and explain what the long run situation will be for both the AE graph and the AS/AD graph. AS / AD LRAS SRAS2 SRAS AD 2 AD1 In the long run because unemployment is low firms will be competing for workers which will drive up wages and shift the SRAS curve to SRAS 2. This pushes the price

9 level even higher to 110, and returns Y to its original level of 400. The increase in the price level will then cause the APE curve to shift down, returning it to its original level. So in the long run an increase in G does not change Y at all, it only increases the price level.