CM 10408 Economics II Written Assignment

Aggregate Demand and Aggregate Supply Tutor: Mr. Tommy Yu Tutorial section: TC1 Team: D (Week 12) Tai Yin Man (52224590) Cheng Ka Chun (52217536) Tsum Lok Tung (52224460) Date: 7-4-2011

Question 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" The statement that The aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods is false. Aggregate demand curve slopes downward because of 3 factors. Changes in price affect the quantity of goods and services demand. Price level increase, and then people dollars holding decreases. It is because the wealth effect, the interest rate effect and exchange rate effect affect the consumption, investment and net export rise or down. Y= C+I+G+NX. But we assume government purchases (G) fixed by government policy. So, this statement is false. (b) The long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply" 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 are the factors such as the rate of inflation, the rate of interest, the monetary policies etc. It is affected the long-run aggregate supply. So, the long-run aggregate-supply curve which is vertical is not because economic forces do not affect long-run aggregate supply. It is because price level does not affect long-run aggregate supply. Since the natural rate of output depend on the amount of labor, technology, immigration etc. Price level does not affect these. So, price level will not affect the long-run aggregate supply. The statement is false. (c) The long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply" The statement If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal" is false. If firms change their prices every day, short-run aggregate-supply would be upward sloping but not horizontal. Due to the sticky prices theory (menu cost), it were one of the

possible cause for the upward slope of the short-run aggregate supply curve. Also, only the prices are fixed would be horizontal. So, the statement is false. (d) Whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left" Whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left" is false. Long-run aggregate-supply shifts to the left does not mean the society enter recession. It means there are ongoing deflation and decrease in output. However, economy could enter a recession only if the short-run aggregate- curve shifts to the left or aggregate demand curve shift to the left. So, the statement is false.

Question 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 Recession mean a period of declining real incomes and rising unemployment, therefore, recovering from a recession that mean we need to increase real income and the employment. Without any policy intervention, we can use The Sticky-Wage Theory, the Sticky-Price Theory and the Misperceptions Theory to make the returns to long-term equilibrium. For The Sticky-Wage Theory, first, the worker and firm expected price level will falls and the real wages are too high with the low labor demand, so that they will bargain with the worker to lower their wages through adjusting the nominal wages, then, the cost of labor will decrease so that the firm can have more capital to increase output and hire more workers when the expected price level is smaller than the actual price level in order to let the production become more profitable. Therefore, the real wages will be adjusted and decline, the economic return to the full employment. For The Sticky-Price Theory, first, because of the increase of overall price level and make adjustment to change the price involve the menu cost, some of the firm will raise their price immediately to response the economic change.

However, some firm will lag behind, not adjust all the prices quickly, so that their prices will lower-than-desired levels and attract more customers, which make the firm increase employment and production. Overtime, the prices will be fully adjust and return to the Long- term aggregate-supply curve. For The Misperceptions Theory, the actual price level by the suppliers was lower than they expected, because some of the suppliers found that the price of their output is declining, because they think that the relative price decrease, their outcome will also decrease. Therefore, it provided an incentive for them to produce fewer products. Until people observe the lower price level and adjust their expectations, therefore, the aggregate-supply will return to Long- term. (b) What determines the speed of that recovery. How quickly the wages, price and price expectations adjust reflect the speed of recovery of The Sticky-Wage Theory, the Sticky-Price Theory and the Misperceptions Theory, respectively. These factors will adjust the aggregate supply return to Long-term equilibrium and determine the speed of recovery.

Question 11
For each of following events, explain the short-run and the long-run effects on the output and the price level, assuming policymakers take no action. (a) The stock market declines sharply, reducing consumers wealth.

Since the stock market declines sharply, the people wealth are being affected. In short run, it leads to a fall in aggregate demand which would shift aggregate-demand curve from AD1 to AD2. The economy is reached from point A to point B because the output level and the price level would fall from Y1 to Y2 and falls from P1 to P2 respectively. Over time, the price level would be adjusted, so the short run aggregate supply curve would shift rightward from AS1 to AS2. As a result, the output level would return to the natural rate of output Y1 and the price level would fall from P2 to P3. And the economy would be reached at point C which is the interaction of new-aggregate demand curve and long-run aggregate-supply curve. (b) The federal government increases spending on national defense.

In short run, the federal government increases spending on national defense means that an increase in government purchases. Thus, the aggregate-demand curve would shift rightward from AD1 to AD2. With the both rising output and price level, the economy would be reached from point A to point B. In long run, as the price level has adjusted, the short run aggregate supply curve shift leftward from AS1 to AS2 to restore the equilibrium at point C. And the price level would rise to P3 and the output would return to the natural rate of output Y1. (c) A technological improvement raises productivity

Since there is an improvement in technology, it raises the productivity. As a result, both the short-run and long-run aggregate supply curve would shift rightward from AS1 to AS2 and from LRAS1 to LRAS2 respectively. The economy would then move from point A to point B as the price level decrease from P1 to P2 and the output increase from Y1 to Y2. (d)A recession overseas causes foreigners to buy fewer U.S. goods.

When there is a recession overseas, it causes the foreigners to buy less U.S.

goods and so decrease the net exports. As a result, the aggregate demand curve would shift to the left. With the declining output and price level, the economy would be reached from point A to point B. Over time, the short-run aggregate-supply curve would shift rightward and thus the economy would move to point C. And, the price level would fall and the output would return back to the natural rate of output Y1.

Qustion 12 Suppose the U.S. economy begins in long-run equilibrium. Concerns about global climate change cause the government to significantly restrict the production of electricity form fossil fuels. Because of this change in policy, foreign investors lose confidence in the economy, and the dollar falls in foreign-exchange markets. Draw a diagram to show the short-term effect of these events, and explain why these changes occur.
Figure 1

The U.S. economy begins in Long-term equilibrium. Yn equal to Y, means the potential output equal to actual output. Pe equal to P and unemployment is at its natural rate.

Figure 2 The foreign investors lose confident to the U.S. economy, so that the investment on U.S. will decrease, it make the Aggregate-Demand curve shift to the left, the outcome and employment decrease, form YN to Y1, and the Price level of U.S. also decrease, form Pe to P1.

Figure 3 Since the U.S. dollar falls in foreign-exchange markets, the dollar of U.S. depreciates in foreign-exchange markets, that mean the purchasing power of foreign currency will increase and buy more U.S products. Therefore, the export of U.S. increase, the Net export (NX) will increase. The AD curve shift to right, outcome return to the Long-term equilibrium (YN) and the price level increase, because the U.S. begins in long-term equilibrium.

Question 13
Suppose firms become very optimistic about future business conditions and invest heavily in new capital equipment. (a) Draw an aggregate-demand / aggregate-supply diagram to show the

short-run effect of this optimism on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplies changes.

If the firms are optimistic about the future business conditions and invest heavily in new capital equipment, it tends to raise the investment and so is the aggregate demand which shift from AD1 to AD2. The economy is reached at point B now. And the price level and output would rise to P2 and Y2 respectively. Besides, as the price level has risen, the aggregate quantity of output would increase due to the misperceptions of the price level, sticky wages and sticky prices.

(b)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.

In long run, the misperceptions of price level would disappear, wages and prices would adjust over time. The short run aggregate supply curve will shift from AS1 to AS2. And so the economy would reach at point C. moreover, the price level and output level would then rise to P3 and fall back to Y1. As the price level increase, due to the Wealth Effect, Interest-Rate Effect and Exchange-Rate Effect, the aggregate quantity of output demanded would decrease.

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

The investment boom would increase the long-run aggregate-supply curve which shift from LRAS to LRAS2 because higher investment today result in a larger capital stock in the future, so it leads to higher productivity and so is output.