Log out Go to App
Go to App

Learning Materials

Features

Discover

Chapter 27: Problem 10

There were two major shocks to the U.S. economy in 2007, leading to the severe recession of \(2007-2009 .\) One shock was related to oil prices; the other was the slump in the housing market. This question analyzes the effect of these two shocks on GDP using the \(A D-A S\) framework. a. Draw typical aggregate demand and short-run aggregate supply curves. Label the horizontal axis "Real GDP" and the vertical axis "Aggregate price level." Label the equilibrium point \(E_{1}\), the equilibrium quantity \(Y_{1},\) and equilibrium price \(P_{1}\). b. Data taken from the Department of Energy indicate that the average price of crude oil in the world increased from \(\$ 54.63\) per barrel on January 5,2007 , to \(\$ 92.93\) on December 28,2007 . Would an increase in oil prices cause a demand shock or a supply shock? Redraw the diagram from part a to illustrate the effect of this shock by shifting the appropriate curve. c. The Housing Price Index, published by the Office of Federal Housing Enterprise Oversight, calculates that U.S. home prices fell by an average of \(3.0 \%\) in the 12 months between January 2007 and January 2008\. Would the fall in home prices cause a supply shock or demand shock? Redraw the diagram from part b to illustrate the effect of this shock by shifting the appropriate curve. Label the new equilibrium point \(E_{3}\), the equilibrium quantity \(Y_{3}\), and equilibrium price \(P_{3}\). d. Compare the equilibrium points \(E_{1}\) and \(E_{3}\) in your diagram for part \(c\). What was the effect of the two shocks on real GDP and the aggregate price level (increase, decrease, or indeterminate)?

Short Answer

Expert verified
Short Answer: Incorporate the information from your analysis into a brief answer, such as: Both the increase in oil prices, causing a supply shock, and the fall in home prices, causing a demand shock, result in a decrease in real GDP. The overall effect on the aggregate price level is indeterminate, as the increase in oil prices leads to a higher price level, while the fall in home prices leads to a lower price level. The final outcome for the aggregate price level depends on the relative magnitude of the shifts in both the AD and SRAS curves.

Step by step solution

01

a. Drawing the AD-AS model

First, let's draw the AD-AS model with the correct labels. On the horizontal axis, we have real GDP (Y), and on the vertical axis, we have the aggregate price level (P). Aggregate demand (AD) curve slopes downward, while the short-run aggregate supply (SRAS) curve slopes upward. The intersection of AD and SRAS gives the equilibrium point E1, with equilibrium price level P1 and equilibrium quantity Y1.
02

b. The effect of the increase in oil prices

Now, let's analyze the impact of the increase in oil prices on the AD-AS model. An increase in oil prices affects the cost of production, which leads to a decrease in aggregate supply. This results in a supply shock rather than a demand shock. To show this impact, we need to shift the SRAS curve to the left, representing a decrease in aggregate supply. This shift will cause a new equilibrium point, higher price level and lower real GDP.
03

c. The effect of the fall in home prices

Next, we need to determine the impact of the fall in home prices on the AD-AS model. A fall in home prices reduces household wealth, which in turn reduces consumer spending -- one of the components of aggregate demand. Therefore, this event causes a demand shock. To show the effect of this shock, we need to shift the AD curve to the left. This shift will create a new equilibrium point (E3) with a lower price level (P3) and lower real GDP (Y3).
04

d. Comparing the equilibrium points and the effects of the shocks

Comparing the equilibrium points E1 and E3, we can see that real GDP decreases (from Y1 to Y3) due to both the increase in oil prices (supply shock) and the fall in home prices (demand shock). The aggregate price level is indeterminate as the increase in oil prices (supply shock) leads to a higher price level, while the fall in the housing market (demand shock) leads to a lower price level. The overall effect on the aggregate price level depends on the magnitude of the shifts in both AD and SRAS curves relative to each other.

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

The Conference Board publishes the Consumer Confidence Index (CCI) every month based on a survey of 5,000 representative U.S. households. It is used by many economists to track the state of the economy. A press release by the Board on June \(28,2011,\) stated: "The Conference Board Consumer Confidence Index, which had declined in May, decreased again in June. The Index now stands at \(58.5(1985=100)\), down from 61.7 in May." a. As an economist, is this news encouraging for economic growth? b. Explain your answer to part a with the help of the \(A D-A S\) model. Draw a typical diagram showing two equilibrium points \(\left(E_{1}\right)\) and \(\left(E_{2}\right) .\) Label the vertical axis "Aggregate price level" and the horizontal axis "Real GDP." Assume that all other major macroeconomic factors remain unchanged. c. How should the government respond to this news? What are some policy measures that could be used to help neutralize the effect of falling consumer confidence?

Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output? a. There is a decrease in households' wealth due to a decline in the stock market. b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases.

In each of the following cases, in the short run, determine whether the events cause a shift of a curve or a movement along a curve. Determine which curve is involved and the direction of the change. a. As a result of an increase in the value of the dollar in relation to other currencies, American producers now pay less in dollar terms for foreign steel, a major commodity used in production. b. An increase in the quantity of money by the Federal Reserve increases the quantity of money that people wish to lend, lowering interest rates. c. Greater union activity leads to higher nominal wages. d. A fall in the aggregate price level increases the purchasing power of households' and firms" money holdings. As a result, they borrow less and lend more.

Suppose that in Wageland all workers sign annual wage contracts each year on January \(1 .\) No matter what happens to prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed. Answer the following questions using a diagram and assume that the economy starts at potential output. a. In the short run, how will the quantity of aggregate output supplied respond to the fall in prices? b. What will happen when firms and workers renegotiate their wages?

A fall in the value of the dollar against other currencies makes U.S. final goods and services cheaper to foreigners even though the U.S. aggregate price level stays the same. As a result, foreigners demand more American aggregate output. Your study partner says that this represents a movement down the aggregate demand curve because foreigners are demanding more in response to a lower price. You, however, insist that this represents a rightward shift of the aggregate demand curve. Who is right? Explain.
See all solutions

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.

Sign-up for free