Short Run Economic Fluctuation

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2. Suppose that the economy is undergoing a recession because of a fall in aggregate demand.

a. Using an aggregate-demand/aggregate-supply diagram, depict the current state of the economy.

 b. What is happening to the unemployment rate?

 c. “Capacity utilization” is a measure of how intensively the capital stock is being used. In a recession, is capacity utilization above or below its long-run average? Explain.
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 3. Explain whether each of the following events will increase, decrease, or have no effect on long-run aggregate supply.

a. The United States experiences a wave of immigration.

 b. Congress raises the minimum wage to $10 per hour.

 c. Intel invents a new and more powerful computer chip.

 d. Asevere hurricane damages factories along the east coast.

a.      When the United States experiences a wave of immigration, the labor force increases, so long-run aggregate supply shifts to the right. 

         b.           When Congress raises the minimum wage to $10 per hour, the natural rate of unemployment rises, so the long-run aggregate-supply curve shifts to the left.

         c.            When Intel invents a new and more powerful computer chip, productivity increases, so long-run aggregate supply increasesbecause more output can be produced with the same inputs. 

         d.           When a severe hurricane damages factories along the East Coast, the capital stock is smaller, so long-run aggregate supply declines.

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4. In Figure 31-8, how does the unemployment rate at points B and C compare to the unemployment rate at point A? Under the sticky-wage explanation of the short-run aggregate-supply curve, how does the real wage at points B and C compare to the real wage at point A?

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 5. Explain why the following statements are false.

 a. “The aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods.”

 b. “The long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply.”

 c. “If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal.”

 d. “Whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left.”

a.      The statement that "the aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods" is false. The aggregate-demand curve slopes downward because a fall in the price level raises the overall quantity of goods and services demanded through the wealth effect, the interest-rate effect, and the exchange-rate effect.

b.     The statement that "the long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply" is false. Economic forces of various kinds (such as population and productivity) do affect long-run aggregate supply. The long-run aggregate-supply curve is vertical because the price level does not affect long-run aggregate supply.

c.      The statement that "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 aggregate-supply curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal only if prices were completely fixed.

d.     The statement that "whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left" is false. An economy could enter a recession if either the aggregate-demand curve or the short-run aggregate-supply curve shifts to the left.

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6. For each of the three theories for the upward slope of the short-run aggregate-supply curve, carefully explain the following:

a. how the economy recovers from a recession and returns to its long-run equilibrium without any policy intervention

a.      According to the sticky-wage theory, the economy is in a recession because the price level has declined so that real wages are too high, thus labor demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment. 

         According to the sticky-price theory, the economy is in a recession because not all prices adjust quickly. Over time, firms are able to adjust their prices more fully, and the economy returns to the long-run aggregate-supply curve.         

         According to the misperceptions theory, the economy is in a recession when the price level is below what was expected. Over time, as people observe the lower price level, their expectations adjust, and the economy returns to the long-run aggregate-supply curve.

b. what determines the speed of that recovery

b.    The speed of the recovery in each theory depends on how quickly price expectations, wages, and prices adjust.

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7. Suppose the Fed expands the money supply, but because the public expects this Fed action, itsimultaneously raises its expectation of the price level. What will happen to output and the price level in the short run? Compare this result to the outcome if the Fed expanded the money supply but the public didn’t change its expectation of the price level.

If the Fed increases the money supply and people expect a higher price level, the aggregate-demand curve shifts to the right and the short-run aggregate-supply curve shifts to the left, as shown in Figure 9.

         The economy moves from point A to point B, with no change in output and a rise in the price level (to P₂).

         If the public does not change its expectation of the price level,the short-run aggregate-supply curve does not shift, the economy ends up at point C, and output increases along with the price level (to P₃).

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8. Suppose that the economy is currently in a recession. If policymakers take no action, how will the economy evolve over time? Explain in words and using an aggregate-demand/aggregate-supply diagram.

Figure 10 depicts an economy in a recession. The short-run aggregate-supply curve is AS₁ and the economy is at equilibrium at point A, which is to the left of the long-run aggregate-supply curve.If policymakers take no action, the economy will return to the long-run aggregate-supply curve over time as the short-run aggregate-supply curve shifts to the right to AS₂. The economy's new equilibrium is at point B.

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9. Suppose workers and firms suddenly believe that inflation will year. Suppose also that the economy begins in long-run equilibrium, and the aggregate-demand curve does not shift.

 a. What happens to nominal wages? What happens to real wages?

b. Using an aggregate-demand/aggregate-supply diagram, show the effect of the change in expectations on both the short-run and long-run levels of prices and output.

 c. Were the expectations of high inflation accurate? Explain.

be quite high over the coming

 10. Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate- demand curve, both, or neither. For each event that does shift a curve, use a diagram to illustrate the effect on the economy.

a. Households decide to save a larger share of their income.

.        If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-demand curve shifts to the left, as shown in Figure 12. The equilibrium changes from point A to point B, so the price level declines and output declines.

 b. Florida orange groves suffer a prolonged period of below-freezing temperatures.

If Florida orange groves suffer a prolonged period of below-freezing temperatures, the orange harvest will be reduced. This decline in the natural rate of output is represented in Figure 13 by a shift to the left in both the short-run and long-run aggregate-supply curves.

         The equilibrium changes from point A to point B, so the price level rises and output declines.

If increased job opportunities cause people to leave the country, the long-run and short-run aggregate-supply curves will shift to the left because there are fewer people producing output. The aggregate-demand curve will shift to the left because there are fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 14 shows. Whether the price level rises or declines depends on the relative sizes of the shifts in the aggregate-demand curve and the aggregate-supply curves.

11. For each of the following events, explain the short-run and long-run effects on output and the price level, assuming policymakers take no action.

a. The stock market declines sharply, reducing consumers’ wealth.

When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left, as shown in Figure 15. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

b. The federal government increases spending on national defense.

      When the federal government increases spending on national defense, the rise in government purchases shifts the aggregate-demand curve to the right, as shown in Figure 16. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate-supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point A.

c. Atechnological improvement raises productivity.

When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 17. The economy moves from point A to point B, as output rises and the price level declines.

d. Arecession overseas causes foreigners to buy fewer U.S. goods.

When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in Figure 18. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A.

12. Suppose that firms become very optimistic about future business conditions and invest heavily in new capital equipment.

a. Use an aggregate-demand/aggregate-supply diagram to show the short-run effect of this optimism on the economy. Label the new levels ofprices and real output. Explain in words why the aggregate quantity of output supplied changes.

a.     If firms become optimistic about future business conditions and increase investment, the result is shown in Figure 20.

            The economy begins at point A with aggregate-demand curve AD₁ and short-run aggregate-supply curve AS₁. The equilibrium has price level P₁ and output level Y₁.

            Increased optimism leads to greater investment, so the aggregate-demand curve shifts to AD₂. Now the economy is at point B, with price level P₂ and output level Y₂.

            The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, wages are sticky, or prices are sticky, all of which cause output supplied to increase.

a.       Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For now, assume there is no change in the long-run aggregate-supply curve.) Explain in words why the aggregate quantity of output demanded changes between the short run and the long run.

b.     Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust, the short-run aggregate-supply curve shifts up to AS₂ and the economy gets to equilibrium at point C, with price level P₃ and output level Y₁. The quantity of output demanded declines as the price level rises. 

c. How might the investment boom affect the long- run aggregate-supply curve? Explain.

c.         The investment boom might increase the long-run aggregate-supply curve because higher investment today means a larger capital stock in the future, thus higher productivity and output