Economics Quiz Week 5

WK5 QUIZ 1 . Explaining short-run economic fluctuations Most economists believe that real economic variables and nominal economic variables behave independently of each other in the long run. For example, an increase in the money supply, a nominal variable, will cause the price level, a nominal variable, to increase but will have no long-run effect on the quantity of goods and services the economy can produce, a real variable. The notion that an increase in the quantity of money will impact the price level but not the output level is known as monetary neutrality . Points: 1/1 Close Explanation Explanation: Real variables measure quantities of goods and services, such as the quantity of a particular good or service produced in an economy or the number of units of one good a unit of another good can buy. Nominal variables, such as the quantity of money or the price level, are measured in terms of dollars. Monetary neutrality is the proposition of classical macroeconomic theory that changes in the money supply affect nominal variables but not real variables. Thus, an increase in the money supply will cause the price level and nominal wages to increase proportionately, but real variables, such as the quantity of output, employment, real wages, and real interest rates, will be unaffected. Most economists accept monetary neutrality as a description of how the economy works in the long run, but not in the short run. In the short run, however, most economists believe that real and nominal variables are intertwined. Economists use the model of aggregate demand and aggregate supply to examine the economy's short-run fluctuations around the long-run output level. The following graph shows an incomplete short-run aggregate demand (AD) and aggregate supply (AS) diagram—it needs appropriate labels for the axes and curves. You will identify some of the missing labels in the questions that follow. VERTICAL AXISHORIZONTAL AXISAD AS The vertical axis of the aggregate demand and aggregate supply model measures the overall price level . Points: 1/1 The aggregate supply curve shows the quantity of goods and services that firms produce and sell at each price level. Points: 1/1 Close Explanation Explanation: The following graph shows the short-run model of aggregate demand and aggregate supply. The price level, a nominal variable, is on the vertical axis, and the quantity of output, a real variable, is on the horizontal axis. The downward-sloping aggregate demand curve shows the quantity of output that governments, consumers, business firms, and foreign customers wish to buy at each price level. The upward-sloping aggregate supply curve shows the quantity of output that firms produce and sell at each price level. PRICE LEVELQUANTITY OF OUTPUTAggregate Demand Aggregate Supply 2 . Why the aggregate demand curve slopes downward The following graph shows the aggregate demand (AD) curve in a hypothetical economy. At point A, the price level is 140, and the quantity of output demanded is $300 billion. Moving down along the aggregate demand curve from point A to point B, the price level falls to 120, and the quantity of output demanded rises to $500 billion. 010020030040050060070080017016015014013012011010090PRICE LEVELOUTPUT (Billions of dollars)AD AB As the price level falls, the cost of borrowing money will demanded to Points: rise . This phenomenon is known as the fall , causing the quantity of output interest rate effect. goods fall. Net exports (exports minus imports) therefore rise, leading to a rise in the quantity of domestic output demanded. The tendency for a fall in the price level to decrease the real exchange rate and increase net exports is known as the exchange rate effect. 3 . Determinants of aggregate demand The following graph shows an increase in aggregate demand (AD) in a hypothetical country. Specifically, aggregate demand shifts to the right from AD1AD1 to AD2AD2, causing the quantity of output demanded to rise at all price levels. For example, at a price level of 140, output is now $400 billion, where previously it was $300 billion. 010020030040050060070080017016015014013012011010090PRICE LEVELOUTPUT (Billions of dollars)AD1 AD2 The following table lists several determinants of aggregate demand. Complete the table by indicating the change in each determinant necessary to increase aggregate demand. Change Needed to Increase AD Wealth Increase Taxes Decrease Expected rate of return on investment Incomes in other countries Increase Increase Points: 1/1 Close Explanation Explanation: The level of consumer spending depends, in part, on household wealth. As household wealth rises, consumer spending rises at each price level. An increase in consumer spending leads to an increase in aggregate demand. A decrease in taxes increases households' disposable income. Households will spend more, causing aggregate demand to increase at each price level. The rate of return that businesses expect on capital projects is a key determinant of investment. Suppose a technological breakthrough causes an increase in the expected return on investment. Investment spending will rise, and aggregate demand will increase at each price level. When the incomes of foreigners increase, foreigners will purchase more domestic products, causing exports to rise. Because net exports are one component of aggregate demand, this increase in net exports (exports minus imports) leads to an increase in aggregate demand at each price level. 4 . The slope and position of the long-run aggregate supply curve Suppose the Fed doubles the growth rate of the quantity of money in the economy. In the long run, the increase in money growth will change which of the following? Check all that apply. The inflation rate The quantity of physical capital The level of technological knowledge The price level Points: 1/1 Close Explanation Explanation: In the long run, the economy's real GDP depends on labor, capital, natural resources, and technological knowledge. Since changes in the quantity of money do not influence these factors, they do not influence the long-run level of output. If the Fed increases money growth, the price level will rise more quickly, and the inflation rate will increase, but the economy's long-run potential output will not change. In the long run, two related propositions hold: Real and nominal variables are separate The position of the long-run aggregate supply curve depends, in part, on the natural rate of unemployment. A policy that increases the natural rate of unemployment will cause the long-run aggregate supply curve to shift to the left. For example, a sharp increase in the minimum wage will increase structural unemployment, thereby raising the natural rate of unemployment and reducing the economy's productive potential. In the following table, determine how each event affects the position of the long-run aggregate supply (LRAS) curve. Direction of LRAS Curve Shif The government allows more immigration of working-age adults who Right find work. This economy's primary source of foreign oil decides to cease exports for Lef political reasons. A government-sponsored training program increases the skill level of the Right workforce. Points: 1/ 1 Close Explanation Explanation: Loosening immigration restrictions will increase the size of the labor force and the economy's productive ability. An increase in labor shifts the long-run aggregate supply curve to the right. If an economy depends on imports from foreign countries for its oil, a politically motivated oil embargo acts like a reduction in natural resources. The reduced availability of natural resources shifts the longrun aggregate supply curve to the left. An effective training program will increase the skill level of the workforce, boosting the economywide stock of human capital. A more knowledgeable workforce will produce more goods and services. The increase in human capital shifts the long-run aggregate supply curve to the right. 5 . Why the aggregate supply curve slopes upward in the short run In the short run, the quantity of output that firms supply can deviate from the natural level of output if the actual price level in the economy deviates from the expected price level. Several theories explain how this might happen. For example, the sticky-price theory asserts that the output prices of some goods and services adjust slowly to changes in the price level. Suppose firms announce the prices for their products in advance, based on an expected price level of 100 for the coming year. Many of the firms sell their goods through catalogs and face high costs of reprinting if they change prices. The actual price level turns out to be 110. Faced with high menu costs, the firms that rely on catalog sales choose not to adjust their prices. Sales from catalogs will rise , and firms that rely on catalogs will respond by increasing the quantity of output they supply. If enough firms face high costs of adjusting prices, the unexpected increase in the price level causes the quantity of output supplied to rise above the natural level of output in the short run. Points: 1/1 Close Explanation Explanation: According to the sticky-price theory, the short-run aggregate supply curve slopes upward because the prices of some products adjust slowly to economic conditions. Some firms set prices for prolonged periods of time because they face high menu costs when prices are adjusted frequently. If the price level turns out to be lower than people expected, the prices of products of firms with more flexible pricing options will be low compared to the prices of products of firms that face high menu costs. Firms with rigid prices will see their sales decline and will cut back on production. An unexpectedly high price level has the opposite effect. Flexible firms will adjust their prices upward, while prices at sticky-price firms will lag behind. Sticky-price firms will see their sales increase because of their relatively low prices, causing them to increase production. Suppose the economy's short-run aggregate supply (AS) curve is given by the following equation: Quantity of Output Suppl iedQuantity of Output Supplied = = Natural Level of Output+α×(Price LevelActual−Price LevelE xpected)Natural Level of Output+α×Price LevelActual−Price LevelExpected unexpectedly low price level of 100 causes firms to supply a quantity of output less than the natural level of output in the short run. The short-run aggregate supply curve is therefore upward sloping: Quantity of Output Suppl iedQuantity of Output Supplied = = Natural Level of Output+α×(Price LevelActual−Price LevelE xpected)Natural Level of Output+α×Price LevelActual−Price LevelExpected = $60 billion+$2 billion×(100−110)$60 billion+$2 billion×100−110 = = $60 billion+(−$20) billion$60 billion+−$20 billion = = $40 billion$40 billion = If the actual price level turns out to be equal to what people expected, output will be equal to the natural level of output: Quantity of Output SuppliedQuantity of Ou = $60 billion+$2 billion×(110−110)$60 billion+$2 tput Supplied = billion×110−110 = = $60 billion$60 billion An unexpectedly high price level of 120 causes firms to supply a quantity of output that exceeds the natural level of output in the short run: Quantity of Output SuppliedQuantity of Ou = $60 billion+$2 billion×(120−110)$60 billion+$2 tput Supplied = billion×120−110 = = = = $60 billion+$20 billion$60 billion+$20 billion $80 billion$80 billion Using the same formula for the remaining price levels produces a short-run aggregate supply curve that goes through the coordinates (40, 100); (50, 105); (60, 110); (70, 115); and (80, 120). 6 . Determinants of aggregate supply The following graph shows a decrease in short-run aggregate supply (AS) in a hypothetical economy where the currency is the dollar. Specifically, the short-run aggregate supply curve shifts to the left from AS1AS1 to AS2AS2, causing the quantity of output supplied at a price level of 100 to fall from $200 billion to $150 billion. 0501001502002503003504002001751501251007550250PRICE LEVELQUANTITY OF OUTPUTAS1 AS2 The following table lists several determinants of short-run aggregate supply. Fill in the table by indicating the changes in the determinants necessary to decrease short-run aggregate supply. Change Needed to Decrease AS Inflation expectations Higher Human capital Declines Burdensome regulations Increase Points: 1/1 Close Explanation Explanation: If workers, landlords, and firms expect higher rates of inflation in the future, they will negotiate existing wage and rent contracts in order to compensate for rising prices. The increase in wages and rents represents an increase in input costs for firms, reducing the quantity of aggregate output supplied at each price level. Higher inflation expectations shift the AS curve to the left. In the short run, the increase in government spending on infrastructure causes the aggregate demand curve to shift to the right, resulting in a higher-than-expected price level (140) and a quantity of output ($700 billion) that exceeds the natural level of output. The increase in production causes firms to hire more workers, so the unemployment rate will fall below the natural rate of unemployment. Again, the following graph shows the economy in long-run equilibrium at the expected price level of 120 and the natural level of output of $600 billion, before the increase in government spending on infrastructure. During the transition from the short run to the long run, price-level expectations will upward and the short-run aggregate supply curve will shift to the adjust left . Points: 1/1 Now show the long-run impact of the increase in government spending by shifting both the aggregate demand (AD) curve and the short-run aggregate supply (AS) curve to the appropriate positions. Your AnswerADAS02004006008001000120024020016012080400PRICE LEVELOUTPUT (Billions of dollars)AD AS1 AS2 Correct Answer Points: 0.5 / 1 In the long run, as a result of the increase in government spending, the price level the quantity of output increases , returns to the natural level of output, and the unemployment rate returns to the natural rate of unemployment. Points: 1/1 Close Explanation Explanation: The increase in government spending on infrastructure shifts the aggregate demand curve rightward in the short run, resulting in a higher-than-expected price level and output above the natural level of output. During the transition from the short run to the long run, the public's price-level expectations will begin to adjust to higher levels. As higher price-level expectations work their way into price and wage contracts, it becomes more costly for firms to hire workers and buy inputs. Consequently, they will cut production at any price level. This is reflected in a leftward shift of the short-run aggregate supply curve (AS). In the long run, the increase in government spending on infrastructure results in a higher price level but output returns to the natural level of output and unemployment returns to the natural rate of unemployment. 8 . Economic fluctuations II The following graph shows the short-run aggregate supply curve (ASAS), the aggregate demand curve (ADAD), and the long-run aggregate supply curve (LRASLRAS) for a hypothetical economy. Initially, the expected price level is equal to the actual price level, and the economy is in long-run equilibrium at its natural level of output, $110 billion. Suppose a bout of severe weather drives up agricultural costs, increases the costs of transporting goods and services, and increases the costs of producing goods and services in this economy. Use the graph to help you answer the questions about the short-run and long-run effects of the increase in production costs that follow. (Note: You will not be graded on any adjustments made to the graph.) Hint: For simplicity, ignore any possible impact of the severe weather on the natural level of output. ADASLRAS90951001051101151201251301301251201151101051009590PRICE LEVELOUTPUT (Billions of dollars)AD AS LRAS The short-run economic outcome resulting from the increase in production costs is known as stagflation . Points: 1/1 Close Explanation Explanation: 90951001051101151201251301301251201151101051009590PRICE LEVELOUTPUT (Billions of dollars)AD1 AD2 AS1 AS2 LRAS 9 . Money Supply Suppose an economy is in long-run equilibrium. The central bank reduces the money supply by 5 percent. Use your diagram to show what happens to output and the price level as the economy moves from the initial to the new short-run equilibrium. Your AnswerAggregate DemandAggregate SupplyPrice LevelQuantity of OutputLRASAD1 AD2 AS1 AS2 Correct Answer Points: 0.5 / 1 Now adjust the graph to show the new long-run equilibrium. What causes the economy to move from its short-run equilibrium to its long-run equilibrium? The government increases spending to increase aggregate demand. Nominal wages, prices, and perceptions adjust downward to this new price level. Nominal wages, prices, and perceptions adjust upward to this new price level. The government increases taxes to curb aggregate demand. Points: 1/1 Close Explanation Explanation: If the central bank reduces the money supply, the aggregate demand curve shifts to the left, with the new short-run equilibrium at point B. Thus, in the short run, both output and the price level decrease. Over time, as nominal wages, prices, and perceptions adjust to the new price level, the short-run aggregate-supply curve shifts to the right, returning the economy to the natural rate of output (point C): Price LevelQuantity of OutputLRASAD1 AD2 AS1 AS2 ABC See Sections: Why the Aggregate-Demand Curve Might Shift; and Why the Aggregate-Supply Curve Is Vertical in the Long Run. Which of the following is true according to the sticky-wage theory of aggregate supply as a result of the decrease in the money supply? Check all that apply. Nominal wages at the initial equilibrium are greater than nominal wages at the new short-run equilibrium. Nominal wages at the initial equilibrium are greater than nominal wages at the new long-run equilibrium. Real wages at the initial equilibrium are less than real wages at the new short-run equilibrium. Real wages at the initial equilibrium are less than real wages at the new long-run equilibrium. Points: 1/1 Judging by the impact of the money supply on nominal and real wages, this analysis is consistent with the proposition that money has real effects in the short run but is neutral in the long run. Points: 1/1 Close Explanation Explanation: According to the sticky-wage theory, nominal wages at points A and B are equal. However, nominal wages at point C are lower. Real wages at point A are lower than real wages at point B. However, real wages at points A and C are equal. This analysis is consistent with long-run monetary neutrality. In the long run, a decrease in the money supply causes a decrease in the nominal wage but leaves the real wage unchanged. See Section: Why the Aggregate-Supply Curve Slopes Upward in the Short Run. 10 . Great Depression True False Points: 1/1 Close Explanation Explanation: The statement “If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal” is false. If firms adjusted prices quickly and if sticky prices were the only possible cause for the upward slope of the short-run aggregate-supply curve, then the short-run aggregatesupply curve would be vertical, not horizontal. The short-run aggregate-supply curve would be horizontal only if prices were completely fixed. See Section: Why the Aggregate-Supply Curve Slopes Upward in the Short Run. 12 . Inflation The economy begins in long-run equilibrium. Then one day, the president appoints a new chair of the Federal Reserve. This new chair is well known for her view that inflation is not a major problem for an economy. Note: You will not be graded on any changes you make to the following graph, but you may use it to help you understand the scenario described. Aggregate DemandAggregate SupplyLRASPrice LevelQuantity of OutputAggregate Demand Aggregate Supply LRAS Which of the following statements accurately describes what would happen as a result of this news? Check all that apply. People would expect the price level to fall. The nominal wage that workers and firms agree to in their new labor contracts would be higher than it would be otherwise. The profitability of producing goods and services at any given price level would decrease. The short-run aggregate-supply curve would shift to the right. Points: 1/1 If aggregate demand is held constant, the shift in the aggregate-supply curve will cause the price level to rise and the quantity of output produced to fall . Points: 1/1 Close Explanation Explanation: People will likely expect that the new chair will not actively fight inflation, so they will expect the price level to rise. If people believe that the price level will be higher over the next year, workers will want higher nominal wages. At any given price level, higher labor costs lead to reduced profitability. The short-run aggregate-supply curve will shift to the left, as shown in the following graph. Price LevelQuantity of OutputAggregate Demand AS1 AS2 LRAS AB A decline in short-run aggregate supply leads to reduced output and a higher price level. This choice to ignore inflation and keep aggregate demand unchanged was probably not wise. The end result is stagflation, which provides limited choices in terms of policies to remedy the situation. See Section: Why the Short-Run Aggregate-Supply Curve Might Shift.