Chapter 28: The Aggregate Expenditures Model

QUESTIONS and ANSWERS 1. What is an investment schedule and how does it differ from an investment demand curve? Answer: An investment schedule shows the level of investment spending for a given level of GDP. An investment demand curve shows how expected rates of profit and real interest rates determine the level of investment spending. In the simple AE model, investment spending is assumed to be independent of the level of real GDP. 2. Why does equilibrium real GDP occur where C + Ig = GDP in a private closed economy? What happens to real GDP when C + Ig exceeds GDP? When C + Ig is less than GDP? What two expenditure components of real GDP are purposely excluded in a private closed economy? Answer: The reason why equilibrium occurs when real GDP equals C + Ig in a private closed economy is because it is at this level output where production creates total spending just sufficient to purchase that output. So the equilibrium level of GDP is the level at which the total quantity of goods produced (GDP) equals the total quantity of goods purchased (C + Ig ). If real GDP (output) exceeds C + Ig the economy will accumulate unplanned inventories. If C + Ig exceeds real GDP (output) the economy will draw down inventories faster than planned. In a private closed economy net exports (closed) and the government sector (private) are both excluded from the analysis. 3. Why is saving called a leakage? Why is planned investment called an injection? Why must saving equal planned investment at equilibrium GDP in the private closed economy? Are unplanned changes in inventories rising, falling, or constant at equilibrium GDP? Explain. Answer: Saving is like a leakage from the flow of aggregate consumption expenditures because saving represents income not spent. Planned investment is an injection because it is spending on capital goods that businesses plan to make regardless of their current level of income. If the two are unequal, there will be a discrepancy between spending and production that will result in unplanned inventory changes. Firms, not wanting inventory levels to change, will change production, implying that equilibrium can only occur when the saving leakage equals the injection of investment spending in a private closed economy. At equilibrium GDP there will be no changes in unplanned inventories because expenditures will exactly equal planned output levels which include consumer goods and services and planned investment. Thus there is no unplanned investment including no unplanned inventory changes. 4. Other things equal, what effect will each of the following changes independently have on the equilibrium level of real GDP in the private closed economy? a. A decline in the real interest rate. b. An overall decrease in the expected rate of return on investment. c. A sizeable, sustained increase in stock prices. Answer: (a) This will increase interest-sensitive consumer purchases and investment, causing GDP to increase. (b) Investment will decrease because of the lower expected rate of return, causing GDP to increase. (c) By increasing consumption (because households will feelor bemore wealthy, or because they are hopeful about an expansion) and by increasing investment, the AE schedule will shift upward, causing the GDP to increase.

5. Assuming the economy is operating below its potential output, what is the impact of an increase in net exports on real GDP? Why is it difficult, if not impossible, for a country to boost its net exports by increasing its tariffs during a global recession? Answer: Like consumption and investment, exports create domestic production, income, and employment for a nation. Although U.S. goods and services produced for export are sent abroad, foreign spending on those goods and services increases production and creates jobs and incomes in the United States. This implies that an increase in net exports results in an increase in aggregate expenditures and an increase in real GDP. However, the use of tariffs to accomplish this goal (boost NET exports) will likely fail because other countries will respond in-kind. That is, if the United States increased tariffs to reduce imports (boost net exports) foreign countries will respond with tariffs on U.S. goods reducing exports from the U.S. (decrease in net exports). 6. What is a recessionary expenditure gap? An inflationary expenditure gap? Which is associated with a positive GDP gap? A negative GDP gap? Answer: A recessionary expenditure gap is the amount by which aggregate expenditures at the full employment GDP fall short of those required to achieve the full employment GDP. Insufficient total spending contracts or depresses the economy. This also is referred to as a negative GDP gap. Economists use the term inflationary expenditure gap to describe the amount by which an economys aggregate expenditures at the full-employment GDP exceed those just necessary to achieve the full-employment level of GDP. This also is referred to as a positive GDP gap. 7. What is Says law? How does it relate to the view held by classical economists that the economy generally will operate at a position on its production possibilities curve (Chapter 1)? Use production possibilities analysis to demonstrate Keynes view on this matter. Answer: Says law states supply creates its own demand. People work in order to earn income to, and plan to, spend the income on output why else would they work? Basically, the classical economists would say that the economy will operate at full employment or on the production possibilities curve because income earned will be recycled or spent on output. Thus the spending flow is continuously recycled in production and earning income. If consumers dont spend all their income, it would be redirected via saving to investment spending on capital goods. The Keynesian perspective, on the other hand, suggests that societys savings will not necessarily all be channeled into investment spending. If this occurs, we have a situation in which aggregate demand is less than potential production. Because producers cannot sell all of the output produced at a full employment level, they will reduce output and employment to meet the aggregate demand (consumption plus investment) and the equilibrium output will be at a point inside the production possibilities curve at less than full employment.

Chapter 28: The Aggregate Expenditures Model

PROBLEMS AND SOLUTIONS

1. If the level of investment is $16 billion and independent of the level of total output, complete the table below and determine
the equilibrium levels of output and employment in this private closed economy. What are the sizes of the MPC and MPS?

The savings column is found by subtracting Consumption from Real Domestic Output (disposable income) for each row. The answers are reported in the savings column below. We can also find aggregate expenditures by adding consumption and investment, which is reported in the last column in the table below. We can find equilibrium two ways. First, we can find the level of output and employment where Investment equals Savings. Second, we can find the level of output and employment where aggregate expenditures equal real output. Either of these approaches give us the equilibrium level of output of $340 billion and a level of employment 65 million. The marginal propensity to consume can be found by dividing the change in consumption by the change in real domestic output. MPC = Consumption/ Real Domestic Output = $16/$20 = 0.8 The marginal propensity to save can be found by subtracting the marginal propensity to consume from one. MPS = 1 - MPC = 1 - 0.8 = 0.2 The expenditure multiplier can be found by dividing one by the marginal propensity or by one minus the marginal propensity to consume. Expenditure multiplier = 1/MPS = 1/(1-MPS) = 1/0.2 = 5

Possible levels of employment (millions) 40 45 50 55 60 65 70 75 80

Real domestic output (GDP=DI) (billions) $240 260 280 300 320 340 360 380 400

Consumption (billions) $244 260 276 292 308 324 340 356 372

Saving (billions) $ -4 0 4 8 12 16 20 24 28

Investment (billions) $16 16 16 16 16 16 16 16 16

Aggregate Expenditures (billions) $260 276 292 308 324 340 356 372 388

2. Using the consumption and saving data in Problem 1 above, and, assuming investment is $16 billion, what are
saving and planned investment at the $380 billion level of domestic output? What are saving and actual investment at that level? What are saving and planned investment at the $300 billion level of domestic output? What are the levels of saving and actual investment? ANSWER: At the $380 billion level of GDP, saving = $24 billion; planned investment = $16 billion (from the question). This deficiency of $8 billion of planned investment causes an unplanned $8 billion increase in inventories. Actual investment is $24 billion (= $16 billion of planned investment plus $8 billion of unplanned inventory investment), matching the $24 billion of actual saving. At the $300 billion level of GDP, saving = $8 billion; planned investment = $16 billion (from the question). This excess of $8 billion of planned investment causes an unplanned $8 billion decline in inventories. Actual investment is $8 billion (= $16 billion of planned investment minus $8 billion of unplanned inventory disinvestment) matching the actual of $8 billion.

3. How much will GDP change if firms increase their investment by $8 billion and the MPC is .80? If the MPC is .67?
ANSWER: First, find the expenditure multiplier. The expenditure multiplier can be found by dividing one by one minus the marginal propensity to consume. Expenditure multiplier = 1/(1-MPC) The Expenditure Multiplier for the first value is 5 (= 1/(1-0.8)). The Expenditure Multiplier for the second value is 3.0303 (= 1/(1-0.67)). Second, to find the change in GDP take the Expenditure Multiplier and multiply this value by the change in investment. For the first MPC value, the change in GDP equals $40 (= 5 x $8). Four the second MPC, the change in GDP equals $24.24 (= 3.0303 x $8).

4. Suppose that a certain country has an MPC of .9 and a real GDP of $400 billion. If its investment spending
decreases by $4 billion, what will be its new level of real GDP? Answer: First, find the expenditure multiplier. Expenditure multiplier = 1/(1-MPC) For the first value, the expenditure multiplier is 10 (= 1/(1-0.9)). Second, to find the change in GDP take the expenditure multiplier and multiply this value by the change in investment. Change in GDP = 10 x (-$4) = -$40 Third, to find the new level of real GDP add the change to the original level of real GDP (note, when investment decreases the change is negative). New level of real GDP = $400 +(-$40) = $400 - $40 = $360

5. The data in columns 1 and 2 in the accompanying table are for a private closed economy:

a. Use columns 1 and 2 to determine the equilibrium GDP for this hypothetical economy. b. Now open up this economy to international trade by including the export and import figures of columns 3 and 4. Fill in columns 5 and 6 and determine the equilibrium GDP for the open economy. What is the change in equilibrium GDP caused by the addition of net exports? c. Given the original $20 billion level of exports, what would be net exports and the equilibrium GDP if imports were $10 billion greater at each level of GDP? d. What is the multiplier in this example?

ANSWERS: Part a: Use columns 1 and 2 to determine the equilibrium GDP for this hypothetical economy. ANSWER: Equilibrium for this economy occurs where Aggregate Expenditures for the Private Closed Economy equals Real Gross Domestic Product. Thus, equilibrium is $400 billion.

Part b: Now open up this economy to international trade by including the export and import figures of columns 3 and 4. Fill in columns 5 and 6 and determine the equilibrium GDP for the open economy. What is the change in equilibrium GDP caused by the addition of net exports?

ANSWER: To find net exports, subtract imports from exports. These answers are reported in column 5 below. To find aggregate expenditures for the open economy, add net exports to the aggregate expenditures for the closed economy. These values are reported in column 6.

(1) Real domestic output (GDP=DI) billions

(2) Aggregate Expenditures , private closed economy, billions

(3)

(4)

(5)

(6)

Net exports, Exports, billions Imports, billions private

Aggregate expenditure s, open

economy billions

$200 $250 $300 $350 $400 $450 $500 $550

$240 $280 $320 $360 $400 $440 $480 $520

$20 $20 $20 $20 $20 $20 $20 $20

$30 $30 $30 $30 $30 $30 $30 $30

-$ 10 -$ 10 -$ 10 -$ 10 -$ 10 -$ 10 -$ 10 -$ 10

$ 230 $ 270 $ 310 $ 350 $ 390 $ 430 $ 470 $ 510

Equilibrium for this economy occurs where Aggregate Expenditures for the Private Open Economy equals Real Gross Domestic Product. Thus, equilibrium is $350 billion. The change in equilibrium GDP is a decrease of $50.

Part c: Given the original $20 billion level of exports, what would be net exports and the equilibrium GDP if imports were $10 billion greater at each level of GDP?

ANSWER: If Imports were $10 billion greater at each level of GDP the following table results:

(1) Real domestic output (GDP=DI) billions

(2) Aggregate Expenditures , private closed economy, billions

(3)

(4)

(5)

(6)

Net exports, Exports, billions Imports, billions private

Aggregate expenditure s, open

economy billions

$200 $250 $300 $350 $400 $450 $500 $550

$240 $280 $320 $360 $400 $440 $480 $520

$20 $20 $20 $20 $20 $20 $20 $20

$40 $40 $40 $40 $40 $40 $40 $40

-$ 20 -$ 20 -$ 20 -$ 20 -$ 20 -$ 20 -$ 20 -$ 20

$ 220 $ 260 $ 300 $ 340 $ 380 $ 420 $ 460 $ 500

Equilibrium for this economy occurs where Aggregate Expenditures for the Private Open Economy equals Real Gross Domestic Product. Thus, equilibrium is $300 billion.

Part d: What is the multiplier in this example? ANSWER: To find the multiplier for this example use either the standard approach using the marginal propensity to consume, or, use the change in real GDP that results from the change in net exports.

The latter approach is used here. The change in net exports equals -$10 billion. The change in real GDP associated with the change in net exports is -$50. Multiplier = real GDP/ net exports = -$50 billion/-$10 billion = 5

Chapter 29: Aggregate Demand and Aggregate Supply

QUESTIONS and ANSWERS

1. Why is the aggregate demand curve downsloping? Specify how your explanation differs from the explanation
for the downsloping demand curve for a single product. What role does the multiplier play in shifts of the aggregate demand curve? Answer: The aggregate demand (AD) curve shows that as the price level drops, purchases of real domestic output increase. The AD curve slopes downward for three reasons. The first is the interest-rate effect. We assume the supply of money to be fixed. When the price level increases, more money is needed to make purchases and pay for inputs. With the money supply fixed, the increased demand for it will drive up its price, the rate of interest. These higher rates will decrease the buying of goods with borrowed money, thus decreasing the amount of real output demanded. The second reason is the real balances effect. As the price level rises, the real valuethe purchasing powerof money and other accumulated financial assets (bonds, for instance) will decrease. People will therefore become poorer in real terms and decrease the quantity demanded of real output. The third reason is the foreign purchases effect. As the United States price level rises relative to other countries, Americans will buy more abroad in preference to their own output. At the same time foreigners, finding American goods and services relatively more expensive, will decrease their buying of American exports. Thus, with increased imports and decreased exports, American net exports decrease and so, therefore, does the quantity demanded of American real output. These reasons for the downsloping AD curve have nothing to do with the reasons for the downsloping singleproduct demand curve. In the case of the dropping price of a single product, the consumer with a constant money income substitutes more of the now relatively cheaper product for those whose prices have not changed. Also, the consumer has become richer in real terms, because of the lower price of the one product, and can buy more of it and all other products. But with the AD curve, moving down the curve means all prices are droppingthe price level is dropping. Therefore, the single-product substitution effect does not apply. Also, whereas when dealing with the demand for a single product the consumers income is assumed to be fixed, the AD curve specifically excludes this assumption. Movement down the AD curve indicates lower prices but, with regard to the circular flow of economic activity, it also indicates lower incomes. If prices are dropping, so must the receipts or revenues or incomes of the sellers. Thus, a decline in the price level does not necessarily imply an increase in the nominal income of the economy as a whole. The multiplier acts on an initial change in spending to generate an even greater shift in the aggregate demand curve.

2. Distinguish between real-balances effect and wealth effect, as the terms are used in this chapter. How does each relate to the aggregate demand curve? Answer: The real balances effect refers to the impact of price level on the purchasing power of asset balances. If prices decline, the purchasing power of assets will rise, so spending at each income level should rise because peoples assets are more valuable. The reverse outcome would occur at higher price levels. The real balances effect is one explanation of the inverse relationship between price level and quantity of expenditures. The wealth effect assumes the price level is constant, but a change in consumer wealth causes a shift in consumer spending; the aggregate expenditures curve will shift right. For example, the value of stock market shares may rise and cause people to feel wealthier and spend more. A stock decline can cause a decline in consumer spending.

3. What assumptions cause the immediate-short-run aggregate supply curve to be horizontal? Why is the long-run aggregate
supply curve vertical? Explain the shape of the short-run aggregate supply curve. Why is the short-run curve relatively flat to the left of the full-employment output and relatively steep to the right? Answer: The immediate short-run supply curve is horizontal because of contractual agreements. These contracts for both input and output prices imply that prices do not change along the immediate short-run aggregate supply curve. The long-run aggregate supply curve is vertical (at the full-employment or potential output) because the economys potential output is determined by the availability and productivity of real resources, not by the price level. The availability and productivity of real resources is reflected in the prices of inputs, and in the long run these input prices (including wages) adjust to match changes in the price level. Firms have no incentive to increase production to take advantage of higher prices if they simultaneously face equally higher resource prices. The shape of the short-run supply curve is upsloping. Wages and other input prices adjust more slowly than the price level, leaving room for firms to take advantage of these higher prices (temporarily) by increasing output. Firms face increasing per unit production costs as they increase output, making higher prices necessary to induce them to produce more. To the left of full-employment output the curve is relatively flat because of the large amounts of unused capacity and idle human resources. Under such conditions, per-unit production costs rise slowly because of the relative abundance of available inputs. Additional resources are easily brought into production, as the suppliers of these resources (especially labor) are anxious to employ them and are happy to accept current prices. To the right of full-employment output the curve is relatively steep because most resources are already employed. Those resources that are not yet in production require higher prices to induce them, or generate higher per-unit production costs because they are less productive than currently employed inputs. Firms trying to increase production bid up input prices as they attempt to attract resources away from other firms. Even if the firm succeeds in pulling resources from another firm, the aggregate increase in output is minimal at best, as resources are merely shifted from one productive process to another.

4. What effects would each of the following have on aggregate demand or aggregate supply, other things equal?
a. A widespread fear by consumers of an impeding economic depression. b. A new national tax on producers based on the value-added between the costs of the inputs and the revenue received from their output. c. A reduction in interest rates at each price level. d. A major increase in spending for health care by the Federal government. e. The general expectation of coming rapid inflation. f. The complete disintegration of OPEC, causing oil prices to fall by one-half. g. A 10 percent across-the-board reduction in personal income tax rates. h. A sizable increase in labor productivity (with no change in nominal wages). i. A 12 percent increase in nominal wages (with no change in productivity). j. An increase in exports that exceeds an increase in imports (not due to tariffs). Answer: (a) AD curve left, output down and price level down (assuming no ratchet effect). (b) AS curve left, output down and price level up. (c) AD curve right, output and price level up. (d) AD curve right, output and price level up (any real improvements in health care resulting from the spending would eventually increase productivity and shift AS right). (e) AD curve right, output and price level up. (f) AS curve right, output up and price level down. (g) AD curve right, output and price level up. (h) AS curve right, output up and price level down. (i) AS curve left, output down and price level up. (j) AD curve right (increased net exports); AS curve left (higher input prices)

5. Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently
operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run? a. An increase in aggregate demand. b. A decrease in aggregate supply, with no change in aggregate demand. c. Equal increases in aggregate demand and aggregate supply. d. A decrease in aggregate demand. e. An increase in aggregate demand that exceeds an increase in aggregate supply. Answer: (a) Price level rises rapidly and little change in real output. (b) Price level rises and real output decreases. (c) Price level does not change, but real output increases. (d) Price level does not change, but real output declines. (e) Price level increases somewhat, as does real output. 6. Explain how an upsloping aggregate supply curve weakens the realized multiplier effect from an initial change in investment spending. Answer: An upsloping aggregate supply curve weakens the effect of the multiplier because any increase in aggregate demand will have both a price and an output effect. For example, if aggregate demand grows by $110 million as a result of increased in investment spending, this could represent an increase of $100 million in real output and $10 million in higher prices if the inflation rate averages 10 percent. The multiplier is weakened because some of the increase in aggregate demand is absorbed by the higher prices and real output does not change by the full extent of the change in aggregate demand. 7. Why does a reduction in aggregate demand in the actual economy reduce real output, rather than the price level? Why might a full-strength multiplier apply to a decrease in aggregate demand? Answer: A reduction in aggregate demand causes a decline in real output rather than the price level because prices are inflexible downward (sticky). If we assume prices are completely inflexible downward, then a reduction in demand is essentially moving leftward and the aggregate supply curve is flat (horizontal), which means reduced output at a constant price. To say prices are completely inflexible downward may be an exaggeration, but prices dont fall easily for several reasons: wage contracts, minimum wage laws, employee morale, fear of price wars and the menu cost notion. Without price changes to mitigate the effects of an aggregate demand change, the multiplier is at full strength. If price were flexible downward, the decrease in spending would lower prices, encouraging some individuals within the macro-economy to spend more, dampening the multiplier effects. 8. Explain: Unemployment can be caused by a decrease of aggregate demand or a decrease of aggregate supply. In each case, specify the price-level outcomes. Answer: The statement is true, although the magnitude of the effect on unemployment can vary considerably, particularly with decreases in aggregate demand. A decrease in aggregate supply will unambiguously increase the price level and reduce real output. With the decrease in output we would expect unemployment to rise. If the economy is operating above its full-employment output, a decrease in aggregate demand will have more modest effects on unemployment, having its strongest impact on the price level (reducing it). If aggregate demand falls while the economy is operating to the left of full-employment output, the increases in unemployment will be more substantial, and the effects on the price level weaker.

Chapter 29: Aggregate Demand and Aggregate Supply

PROBLEMS AND SOLUTIONS

1. Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth and that investment
spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. Also assume that the economys multiplier is 4. If household wealth falls by 5 percent because of declining house values, and the real interest rate falls by two percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level? In what direction and by how much will it eventually shift? Answers: Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth. If household wealth falls by 5 percent because of declining house values the initial shift in aggregate demand will be to the left (decline in real GDP) by $25 billion ( = 5 (percent decline in wealth) x $5 (consumer spending for every 1% change)). Note the positive relationship between wealth and consumer spending. Also, suppose that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. If the real interest rate falls by two percentage points the initial shift in aggregate demand will be to the right (increase in real GDP) by $40 billion ( = 2 (percentage point decline in interest rate) x $20 (investment spending for every 1 percentage point change)). Note the inverse relationship between the interest rate and investment. The combined initial effect is a shift to the right of the aggregate demand curve by $15 billion. There is a decrease of $25 billion from consumer expenditure and an increase of $40 billion from investment expenditure, thus, the net effect is a positive $15 billion. Given that the multiplier is 4, the aggregate demand curve will shift to the right by $60 billion after the multiplier process works its way through the economy ( = 4 (multiplier) x $15 billion (initial net impact on aggregate demand).

2. Answer the following questions on the basis of the three sets of data for the country of North Vaudeville:

a. Which set of data illustrates aggregate supply in the immediate short-run in North Vaudeville? The short run? The long run? b. Assuming no change in hours of work, if real output per hour of work increases by 10 percent, what will be the new levels of real GDP in the right column of A? Does the new data reflect an increase in aggregate supply or does it indicate a decrease in aggregate supply? Part a: Which set of data illustrates aggregate supply in the immediate short-run in North Vaudeville? ANSWER: The data in B. The price level does not have time to adjust in the immediate short-run. Only output can change. Which set of data illustrates aggregate supply in the short-run in North Vaudeville? ANSWER: The data in A. The price level only has time to partially adjust in the short-run. Both the price level and output can change. Which set of data illustrates aggregate supply in the long-run in North Vaudeville? ANSWER: The data in C. The price level has time to completely adjust in the long-run. Only price will change. Part b: To find the new level of output at each price level multiply the original values by 1.1. Price level 110: New output equals 302.5 (=1.1 x 275) Price level 100: New output equals 275 (=1.1 x 250) Price level 95: New output equals 247.5 (=1.1 x 225) Price level 90: New output equals 220 (=1.1 x 200)

This is an increase in aggregate supply because output has increased at every price level.

3. If the aggregate demand and aggregate supply schedules for a hypothetical economy are as shown below:

a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is the equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the equilibrium real output also necessarily the fullemployment real output? b. If the price level in this economy is 150, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? If the price level is 250, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? c. Suppose that buyers desire to purchase $200 billion of extra real output at each price level. Sketch in the new aggregate demand curve as AD1. What is the new equilibrium price level and level of real output?

Answer:
(a) See the graph. Equilibrium price level = 200, which occurs where aggregate supply equals aggregate demand, Thus the equilibrium real output = $300 billion. No, the full-capacity level of GDP cannot be determined without more information.

(b) At a price level of 150, real GDP supplied is a maximum of $200 billion, less than the real GDP demanded of $400 billion. Thus, quantity demanded exceeds the quantity supplied by $200 billion. At a price level of 250, real GDP supplied is $400 billion, which is more than the real GDP demanded of $200 billion. Thus, quantity demanded falls short of the quantity supplied by $200 billion. (c) See the graph from part a. Increases in consumer, investment, government, or net export spending might shift the AD curve rightward. The new values for the aggregate demand schedule are:
Amount of Real GDP Demanded, Billions $300 (=$100 + $200) $400 (=$200 + $200) $500 (=$300 + $200) $600 (=$400 + $200) $700 (=$500 + $200) Price Level (Price Index) 300 250 200 150 100 Amount of Real GDP Supplied, Billions $450 400 300 200 100

The new equilibrium price level = 250 where aggregate supply equals aggregate demand. The new equilibrium GDP = $400 billion.

4. The table below shows an economys relationship between real output and the inputs needed to produce that output:

a. What is productivity in this economy? b. What is the per-unit cost of production if the price of each input unit is $2? c. Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What is the new per-unit cost of production? In what direction would the $1 increase in input price push the economys aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? d. Suppose that the increase in input price does not occur but, instead, that productivity increases by 100 percent. What would be the new per-unit cost of production? What effect would this change in per-unit production cost have on the economys aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output?

Answers:
Part a: What is productivity in this economy? Productivity is defined by how much output each unit of the input produces. Productivity = Real GDP / Input Quantity You can use any of the three combinations above. Productivity = $400 / 150 = 2.6667 Part b: What is the per-unit cost of production if the price of each input unit is $2? The per unit cost is defined by how much each unit of output costs to produce. The total cost of production equals $300 (you can use any combination above) when real GDP is $400. Per unit cost = (price of input unit x input quantity) / real GDP For the values above, per unit cost = ($2 x 150) / $400 =$300 / $400 = $0.75 Part c: Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What is the new per-unit cost of production? In what direction would the $1 increase in input price push the economys aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? The new per unit cost = ($3 x 150) / $400 =$450 / $400 = $1.125. This would cause firms to raise prices at every level of output (higher input cost), thus the aggregate supply schedule would shift left. This would cause output to decrease and prices to rise in short-run. Part d: Suppose that the increase in input price does not occur but, instead, that productivity increases by 100 percent. What would be the new per-unit cost of production? What effect would this change in per-unit production cost have on the economys aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? If productivity increases by 100%, this implies output will double at every input quantity. Real GDP will now be $800 at the input quantity of 150. New productivity = 2 x 2.6667 (original productivity) = 5.3334

From this we can find the required level of real GDP.

Productivity = Real GDP / Input Quantity or 5.3334 = Real GDP / 150 Thus, real GDP = $800 = 150 x 5.3334 (rounding).

Once we have the new level of real GDP we can find the per unit cost.
Per unit cost = (price of input unit x input quantity) / real GDP Per unit cost = ($2 x 150) / $800 = $0.375 This reduction in per unit cost will increase the supply of goods at every price level, thus the aggregate supply schedule will shift to the right. This will cause prices to fall and output to increase in the short run.