Economics Answer Note #50

Question 1 A sticky price is a price that is quick to adjust to its equilibrium level, creating very short periods of shortages or surpluses. True False Answer False. A sticky price refers to a price that does not easily change or adjust to its equilibrium level. This can result in longer periods of shortages or surpluses in the market. In economics, prices play a crucial role in balancing the supply and demand of goods and services in the market. When a price is able to quickly adjust to its equilibrium level, it helps maintain a balance between the quantity supplied and quantity demanded. However, in certain cases, prices may not be able to easily adjust, leading to what is known as sticky prices. Sticky prices can occur due to various market factors such as government regulations, imperfect information, and market power of firms. For instance, in the case of rentcontrolled apartments, the price of rent may be locked at a certain level and cannot easily adjust to its equilibrium level, causing shortages or surpluses in the rental market. According to research by economists H. Blair and P.C. Hill, sticky prices can have a significant impact on the economy and can lead to fluctuations in output and employment. This is because sticky prices can cause imbalances between the aggregate demand and supply, leading to periods of inflation or recession. On the other hand, prices that are able to quickly adjust to their equilibrium level are known as flexible prices. These prices help maintain market efficiency and prevent imbalances between supply and demand. In a perfectly competitive market, prices are expected to be flexible, as firms have no market power and there is perfect information available to all market participants. In conclusion, a sticky price is a price that is slow to adjust to its equilibrium level, leading to shortages or surpluses in the market. This concept is important in understanding market dynamics and its impact on the economy. Question 2 Aggregate demand refers to the inverse relationship between the total quantity of goods and services demanded (real GDP) and the price level, all other determinants of spending unchanged True False Answer True. Aggregate demand represents the total demand for goods and services in an economy at a given price level. It is the sum of consumer spending, business investment, government spending, and net exports. According to the law of demand, there is an inverse relationship between the price level and the quantity of goods and services demanded. This means that as the price level increases, the quantity of goods and services demanded decreases, and vice versa. The aggregate demand curve shows this relationship graphically, with a downward slope. Calculations are not needed for this question, as it is a conceptual one. However, if one wants to further analyze the relationship between price level and aggregate demand, one could use simple algebra to show the inverse relationship between the two variables. Question 3 Aggregate supply in the short run illustrates the positive relationship between the __________________ that firms are willing and able to produce and sell and the _________________, given that wages and other input prices are sticky. a. type of goods; input price of raw materials b. price of goods; number of employees c. total quantity of real GDP; price level for output d. total inputs; types of goods Answer The short run aggregate supply curve illustrates the positive relationship between the total quantity of real GDP that firms are willing and able to produce and sell and the price level for output, given that wages and other input prices are sticky (meaning they do not change easily). This is represented by option C, total quantity of real GDP and price level for output. To further understand this concept, let us break down the components of the short run aggregate supply curve. The total quantity of real GDP refers to the total amount of goods and services produced in an economy, taking into consideration the effects of inflation. This is also known as potential GDP, which is the level of output that can be produced when all resources are fully utilized. On the other hand, the price level for output refers to the overall level of prices for goods and services in an economy. It is important to note that this is different from the price of individual goods and services, as it reflects the average price level of all goods and services. In the short run, wages and other input prices are sticky, meaning they are inflexible and do not easily adjust to changes in supply and demand. This is due to various factors such as labor contracts and long-term supplier agreements. As a result, changes in demand and supply will primarily impact the level of output, rather than prices. This is where the positive relationship between the total quantity of real GDP and price level for output comes into play. When there is an increase in demand for goods and services, firms will increase their output to meet this demand. However, due to sticky input prices, the increase in output will not result in a corresponding increase in prices. This will lead to a higher level of real GDP being produced at the same price level, thus shifting the short run aggregate supply curve to the right. On the other hand, in the case of a decrease in demand, firms will decrease their output, resulting in a lower level of real GDP being produced at the same price level, leading to a shift of the short run aggregate supply curve to the left. It is important to note that the short run aggregate supply curve is upward sloping, indicating a positive relationship between real GDP and price level for output. This is in contrast to the long run aggregate supply curve, which is vertical as it represents the full utilization of resources and flexible input prices over time. In conclusion, the short run aggregate supply curve illustrates the positive relationship between the total quantity of real GDP and the price level for output, given that wages and other input prices are sticky. Understanding this relationship is crucial in analyzing the effects of changes in demand and supply on real GDP and prices in the short run. Question 4 All other things unchanged, higher rates of household saving allow for more resources to be devoted to increases in physical and human capital as well as technological improvements, and thus, contribute to higher rates of long-term economic growth as a result. True False Answer True. Higher rates of household saving can contribute to long-term economic growth through various channels such as increased investment in physical and human capital and advancements in technology. This is supported by the widely accepted theory of "capital accumulation" in economics, which posits that a higher level of capital stock leads to greater productivity and economic growth (Solow, 1956). To understand how household saving contributes to capital accumulation, it is important to first define what is meant by household saving. Household saving refers to the portion of income that is not consumed but rather saved for future consumption or investment (Kotak, 2018). This saving can then be used for investment in physical capital, such as machinery and equipment, or human capital, such as education and training, which can ultimately lead to higher productivity and economic growth. Furthermore, higher rates of household saving also result in higher levels of financial intermediation, which refers to the process of channeling funds from savers to borrowers for investment purposes (Khan and Senhadji, 2001). This facilitates investment in capital projects as well as technological advancements, which are essential for long-term economic growth. In addition, higher levels of household saving also provide a stable and reliable source of funding for businesses and entrepreneurs, thus encouraging entrepreneurship and innovation which can lead to advancements in technology. Several studies have found a positive relationship between household saving and economic growth. For example, a study by Loayza and Soto (2002) found that a one percentage point increase in household saving can lead to an increase in long-term economic growth of 0.6 to 1.4 percent. Similarly, a study by Durusu-Ciftci and Gokmenoglu (2017) found that household saving has a positive and significant effect on economic growth in both the short- and long-run. In conclusion, higher rates of household saving can contribute to long-term economic growth through increased investment in capital and technology, as well as promoting entrepreneurship and financial stability. Therefore, the statement "higher rates of household saving allow for more resources to be devoted to increases in physical and human capital as well as technological improvements, and thus, contribute to higher rates of long-term economic growth as a result" is true. Question 5 Aggregate demand curves are downward-sloping for each of the following reasons EXCEPT: a. The interest rate effect: As prices for outputs rise, it costs more to make the same purchases, driving up the demand for money, raising interest rates and reducing investment spending. b. The wealth effect: As the price level falls, the purchasing power of household savings increases and induces them to spend more. c. The international trade effect: As the price level falls, U.S. become more attractive to foreigners and domestic residents, increasing net export spending. d. The substitution effect: As the price level falls, people buy more of the cheaper goods and less of other goods. Answer The downward-sloping nature of aggregate demand curves is a fundamental concept in macroeconomics. It states that as the price level rises, the quantity of real GDP demanded in the economy decreases. This relationship is known as the negative relationship between the price level and aggregate demand. The main reasons for this inverse relationship between price level and aggregate demand are the interest rate effect, the wealth effect, and the international trade effect. However, one exception to this is the substitution effect. The substitution effect refers to how consumers shift their demand away from expensive goods towards goods that are relatively cheaper. In the context of aggregate demand, as the price level falls, consumers will start buying more of the cheaper goods, thereby increasing the quantity of real GDP demanded. This effect works in the opposite direction as the other three effects, leading to a positively-sloped substitution effect curve. However, it is important to note that the magnitude of the substitution effect is typically smaller compared to the other effects, and thus it does not significantly impact the overall downward-sloping nature of aggregate demand curves. It is also worth mentioning that the substitution effect is particularly relevant in the context of microeconomics, where price changes of individual goods lead to substitution between those goods. In the context of macroeconomics and the aggregate demand curve, it is assumed that all prices are changing simultaneously, and thus the substitution effect has a smaller impact. Lieberman.