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Chapter 27: Problem 12

Using aggregate demand, short-run aggregate supply, and long-run aggregate supply curves, explain the process by which each of the following government policies 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 an increase in taxes on households. b. There is an increase in the quantity of money. c. There is an increase in government spending.

Short Answer

Expert verified
Answer: In the short-run and long-run, the effects are as follows: 1. For an increase in taxes on households: - Short-run: Output decreases, aggregate price level decreases. - Long-run: Output unchanged, aggregate price level decreases. 2. For an increase in the quantity of money: - Short-run: Output increases, aggregate price level increases. - Long-run: Output unchanged, aggregate price level increases. 3. For an increase in government spending: - Short-run: Output increases, aggregate price level increases. - Long-run: Output increases, aggregate price level may increase or remain unchanged.

Step by step solution

01

Explain the impact on aggregate demand

An increase in taxes on households will reduce disposable income, leading to lower consumption. As consumption is a significant component of aggregate demand, this will cause the AD curve to shift to the left.
02

Short-run effects

In the short run, the new equilibrium point occurs at the intersection of the new AD curve and the original SRAS curve. Due to the reduction in aggregate demand, output will decrease, and the aggregate price level will decrease. \[ \left. \begin{array}{ll} \text{Output:} & \text{Decrease} \\ \text{Aggregate Price Level:} & \text{Decrease} \end{array} \right\} \text{Short-run Effects} \]
03

Long-run effects

In response to lower output, firms will reduce production and lower wages, causing the SRAS curve to shift rightward until it intersects the new AD curve and the original LRAS curve. The economy moves to a new long-run equilibrium with a lower price level but the same level of output as the original equilibrium. \[ \left. \begin{array}{ll} \text{Output:} & \text{No change} \\ \text{Aggregate Price Level:} & \text{Decrease} \end{array} \right\} \text{Long-run Effects} \] #b. Increase in the Quantity of Money#
04

Explain the impact on aggregate demand

An increase in the money supply will lead to lower interest rates, encouraging investment and consumption. This increase in investment and consumption will shift the AD curve to the right.
05

Short-run effects

In the short run, the new equilibrium point occurs at the intersection of the new AD curve and the original SRAS curve. Due to the expansion in aggregate demand, output will increase, and the aggregate price level will increase. \[ \left. \begin{array}{ll} \text{Output:} & \text{Increase} \\ \text{Aggregate Price Level:} & \text{Increase} \end{array} \right\} \text{Short-run Effects} \]
06

Long-run effects

In the long run, the higher price level will cause workers to demand higher wages, shifting the SRAS curve leftward until it intersects the new AD curve and the original LRAS curve. The economy moves to a new long-run equilibrium with a higher price level but the same level of output as the original equilibrium. \[ \left. \begin{array}{ll} \text{Output:} & \text{No change} \\ \text{Aggregate Price Level:} & \text{Increase} \end{array} \right\} \text{Long-run Effects} \] #c. Increase in Government Spending#
07

Explain the impact on aggregate demand

An increase in government spending will directly increase aggregate demand, leading to a rightward shift in the AD curve.
08

Short-run effects

In the short run, the new equilibrium point occurs at the intersection of the new AD curve and the original SRAS curve. Due to the expansion in aggregate demand, output will increase, and the aggregate price level will increase. \[ \left. \begin{array}{ll} \text{Output:} & \text{Increase} \\ \text{Aggregate Price Level:} & \text{Increase} \end{array} \right\} \text{Short-run Effects} \]
09

Long-run effects

In the long run, the higher aggregate demand has the potential to increase the productive capacity of the economy by encouraging investment. This will shift the LRAS curve to the right. The new long-run equilibrium will have higher output and potentially a higher or unchanged price level (depending on the relative shifts in the AD, SRAS, and LRAS curves). \[ \left. \begin{array}{ll} \text{Output:} & \text{Increase} \\ \text{Aggregate Price Level:} & \text{Increase or No change} \end{array} \right\} \text{Long-run Effects} \]

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Most popular questions from this chapter

Suppose that the economy is currently at potential output. Also suppose that you are an economic policy maker and that a college economics student asks you to rank, if possible, your most preferred to least preferred type of shock: positive demand shock, negative demand shock, positive supply shock, negative supply shock. How would you rank them and why?

Your study partner is confused by the upward-sloping short-run aggregate supply curve and the vertical longrun aggregate supply curve. How would you explain this?

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.

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?

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)?
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