Name: Solutions Department of Economics Professor Dowell California State University, Sacramento Spring 2013 Problem Set #5 Due in hard copy at beginning of lecture on Monday, April 8, 2013 Important: Place all answers in the indicated spaces. Only your work and answers in the indicated spaces will be graded. All pages must be in order and stapled together. 1. Suppose there is a sharp and sustained increase in the price of oil say to $250 per barrel. a. Using and AS-AD diagram, illustrate the effects of this on output and the price level. What do we call this situation? P AS 2 AS 1 AD AS shifts to the left from AS 1 to AS 2 (decreases) causing an increase in the price level and a reduction in output. The reduction in output will be accompanied by an increase in unemployment. This situation is Y Page 1 of 5
b. Discuss the policy options for responding to this situation addressing both expansionary and contractionary policy. What are the positive and negative effects of each? In this situation there are no good policy responses. If we are going to try to correct the decline in output and rise in unemployment, we need to stimulate aggregate demand. The problem with this though is that it increases prices even more resulting in a higher inflation rate. If on the other hand, we try to return the price level to its original level, we would use contractionary policy. This of course makes the fall in output and rise in unemployment even worse. 2. Suppose our economy starts out at a full employment equilibrium in which output is equal to Y POT. a. Illustrate this situation on the AS-AD diagram below: P LRAS AS 2 P 3 P 2 P 1 AS 1 Equilibrium occurs at the intersection of AD 1, AS 1 and LRAS with output equal to Y POT and at price level P 1 AD 2 Y POT Y 1 AD 1 Y Page 2 of 5
b. Suppose that Congress enacts a massive tax cut in an effort to stimulate the economy prior to an election. Show the effects of this in the above diagram. This will shift AD to the right to AD 2 resulting in an increase in the price level to P 2 and and increase in output to Y 1. c. Explain the adjustment process by which we will return to potential output in the long-run. Be sure to reference the labor market. Due the price increase real wages have fallen. Ultimately workers will demand an increase in their nominal wage in order to restore their real wage. This shifts the labor supply curve to the left in the labor market and shifts AS to the left in the output market (AS-AD diagram) returning us to Y POT, but at a price level P 3 which is a higher price level than that which we were initially d. What is the primary factor determining how quickly we return to potential output? The adjustment speed is determined by the speed with which expectations change and wages adjust. If workers expect the price increase and demand wage increases in anticipation of the price increase, the shift of AS will take place almost immediately. In the extreme case, AS can even shift before AD in which case the economy will not be driven above Y POT even briefly. Page 3 of 5
3. Suppose the dollar depreciates. What will be the effect of this depreciation on equilibrium output and prices? Explain in as much detail as you can. The dollar depreciation effects both AD and AS. With respect to AD, it increases the dollar price and reduces the quantity of our imports while it also decreases the foreign currency price and increases the quantity of our exports. The net result of these two effects is an increase in net exports and AD. The AD curve shifts to the right. On the supply sided, the depreciation of the dollar increases the dollar price of imported inputs leading to a reduction (or leftward shift) of AS. The net result is an increase in the price level and an indeterminate effect on output. Currency depreciation is inflationary. 5. a. Briefly explain three reasons why wages tend to be sticky in the downward direction. Three reasons are minimum wage laws, psychological barriers and the broad category of efficiency wage arguments. The first is self explanatory. Briefly, the second is the fact that workers generally are not predisposed to underbid each other s wages. Efficiency wage arguments are based on the idea that employers who reduce wages will lose their best most productive workers to other employers. Hence, the resist wage cuts. Note that we have seen relatively wide spread wage cuts as a result of the recent recession. This has not been typical of most previous recessions and likely is due to the severity of the 2007-2009 recession. b. What does the stickiness of wages imply regarding the ability of the economy to automatically adjust to eliminate a recessionary gap? It will be a very slow process. The economy will likely get stuck at an equilibrium that is below potential output. Page 4 of 5
6. a. Give three reasons why the aggregate demand curve slopes downward. There are three effects: The wealth effect in which increases in the price level reduce the real value of wealth and hence of the quantity of aggregate output demanded. Second is the interest rate effect in which increases in the price level decreases the real value of wealth as in the wealth effect. When the interest rate effect is operating though, the reduced real wealth results in a decrease in saving (reducing the supply of loanable funds) and increasing the interest rate resulting in a decrease in investment and the quantity of aggregate output demanded. Third is the international trade effect in which rising prices in the U.S. means that our goods are now more expensive relative to foreign goods. As a result we import more and export less causing net exports to fall and reducing the quantity of aggregate output demanded b. Give the primary reasons why the aggregate supply curve slopes upward. Output prices are less sticky than input prices. As the amount of output increases in response to rising overall prices, firms can, in the short-run, continue to buy inputs at fixed prices making it profitable to produce more output. c. What causes the AD curve to shift to the right? There are a number of factors we have discussed so far. From chapter 14, we have the following: 1. An increase in real wealth due to anything other than a change in the price level 2. An increase in expected income which increases consumption today due to consumption smoothing 3. An increase in expected future prices which increases AD today as people try to beat the price increase. 4. An increase in foreign income 5. An increase in the value of the dollar which makes imports less expensive to U.S. consumers and also makes exports more expensive to foreign consumers. The net effect is a decrease in net exports. Additionally, as discussed in the chapters on fiscal policy, an increase in government spending, a decrease in taxes or an increase in transfer payments all result in a rightward shift (increase) in aggregate demand. d. What causes the short run aggregate supply curve to shift to the right? There are three factors: 1. A positive supply shock such as a reduction in the price of a key input. 2. A decrease in the expected future price level means a decrease in nominal wages as new contracts re negotiated leading to an increase in AS. 3. A correction in past expectations of inflation. If inflation is less than expected, wages adjust downward 9increasing AS. e. What causes the long run aggregate supply curve to shift to the right? An increase in resources or technology will shift LRAS (as well as AS) to the right.. Page 5 of 5