Why is the long run aggregate supply curve vertical

99.

Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = 1.0. The aggregate demand curve is Y = 2(M/P) and M = 1,500.

a.

If the economy is initially in long-run equilibrium, what are the values of P and Y?

b.

If M increases to 2,000, what are the new short-run values of P and Y?

c.

Once the economy adjusts to long-run equilibrium at M = 2,000, what are P and Y?

Answer:

a.

P = 1.0; Y = 3,000

b.

P = 1.0; Y = 4,000

c.

P = 1.333; Y = 3,000

100.

Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = 1.0. The aggregate demand curve is Y = 2(M/P) and M = 1,500.

a.

If the economy is initially in long-run equilibrium, what are the values of P and Y?

b.

What is the velocity of money in this case?

c.

Suppose because banks start paying interest on checking accounts, the aggregate demand function shifts to Y = (1.5)(M/P). What are the short-run values of P and Y?

d.

What is the velocity of money in this case?

e.

With the new aggregate demand function, once the economy adjusts to long-run equilibrium, what are P and Y?

f.

What is the velocity now?

Answer :

a.

P = 1.0; Y = 3,000

b.

velocity = 2

c.

P = 1.0; Y = 2,250

d.

velocity = 1.5

e.

P = 0.75; Y = 3,000

f.

velocity = 1.5

101.

Assume that the long-run aggregate supply curve is vertical at Y = 3,000 while the short-run aggregate supply curve is horizontal at P = 1.0. The aggregate demand curve is Y = 3(M/P) and M = 1,000.

a.

If the economy is initially in long-run equilibrium, what are the values of P and Y?

b.

Now suppose a supply shock moves the short-run aggregate supply curve to P = 1.5. What are the new short-run P and Y?

c.

If the aggregate demand curve and long-run aggregate supply curve are unchanged, what are the long-run equilibrium P and Y after the supply shock?

d.

Suppose that after the supply shock the Fed wanted to hold output at its long-run level. What level of M would be required? If this level of M were maintained, what would be long-run equilibrium P and Y?

Answer

a.

P = 1.0; Y = 3,000

b.

P = 1.5; Y = 2,000

c.

P = 1.0; Y = 3,000

d.

M = 1,500; P = 1.5; Y = 3,000

102.

The principal method used by the Federal Reserve to change the money supply is through open-market operations. Use the aggregate demand–aggregate supply model to illustrate graphically the impact in the short run and the long run of a Federal Reserve decision to increase open-market purchases. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values. State in words what happens to prices and output in the short run and the long run.

Answer

In the short run, output increases, while the price level remains unchanged. In the long run, prices increase and output returns to the full-employment level.

103.

The advent of interest-earning checking accounts in the early 1980s led many households to keep a larger proportion of their wealth in checking accounts. Use the aggregate demand–aggregate supply model to illustrate graphically the impact in the short run and the long run of this change in money demand. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values. State in words what happens to prices and output in the short run and the long run.

Answer:

In the short run, output decreases, while the price level remains unchanged. In the long run, prices decrease and output returns to the full-employment level.

104.

Suppose that droughts in the Southeast and floods in the Midwest substantially reduce food production in the United States. Use the aggregate demand–aggregate supply model to illustrate graphically the impact in the short run and the long run of this adverse supply shock. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values. State in words what happens to prices and output in the short run and the long run.

Answer:

In the short run, output decreases, while the price level increases. In the long run, prices decrease and output returns to the full-employment level.

105.

Suppose that laws are passed banning labor unions and that resulting lower labor costs are passed along to consumers in the form of lower prices. Use the aggregate demand–aggregate supply model to illustrate graphically the impact in the short run and the long run of this favorable supply shock. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values. State in words what happens to prices and output in the short run and the long run.

Answer:

In the short run output increases, while the price level decreases. In the long run, prices increase and output returns to the full-employment level.

106.

Suppose you are an economist working for the Federal Reserve when droughts in the Southeast and floods in the Midwest substantially reduce food production in the United States. Use the aggregate demand–aggregate supply model to illustrate graphically your policy recommendation to accommodate this adverse supply shock, assuming that your top priority is maintaining full employment in the economy. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values. State in words what happens to prices and output as a combined result of the supply shock and the recommended Federal Reserve accommodation.

Answer:

The accommodation policy means that the price level is permanently higher, but output is at the full-employment level.

107.

Throughout much of the 1990s, the United States experienced declining energy prices. Assume that the U.S. economy was in long-run equilibrium before these declines began.

a.

Use the aggregate demand–aggregate supply model to illustrate graphically the short-run and long-run impact of this decline on output and prices.

b.

If the Federal Reserve attempted to offset this deviation from the natural rate in the short run, should the money supply be increased or decreased?

Answer:

Output increases and prices decrease in the short run to point B. Output and prices return to their original levels at point A in the long run.

b.

The Federal Reserve must reduce the money supply in the short run, in order to return the economy to the natural rate, moving the economy to point C with a permanently lower price level.

108.

The long-run and short-run aggregate supply curves reflect fundamental differences between long-run and short-run macroeconomic analysis.

a.

Graphically illustrate the long-run and short-run aggregate supply curves. Be sure to label the axes.

b.

What determines the level of output in the long run versus the short run?

c.

How do prices behave differently in the long run and the short run?

Answer:

a.

b.

In the long run, output is determined by the factors of production and technology, but in the short run, output is determined by demand.

c.

In the long run, prices are flexible, but in the short run, prices are sticky.

109.

The economy of Macroland is initially in long-run equilibrium. A severe drought causes an adverse supply shock.

a.

What happens to prices and output in the short run?

b.

What would happen to prices and output in the long run if there is no policy accommodation?

c.

If the Central Bank of Macroland wants to prevent the short-run changes in price and output, what policy action could it take? How would the results of this policy action differ from the prices and output that would result in the long run with no policy action?

Answer

a.

In the short run, prices increase and output decreases.

b.

With no policy accommodation, both output and prices would return to their initial long-run equilibrium levels.

c.

The central bank could increase the money supply to return output to full employment, but this would result in a long-run equilibrium at a higher price level than the initial long-run equilibrium.

110.

A central bank reduces the money supply in an economy initially in long-run equilibrium.

a.

What will happen to output and prices in the short run?

b.

What will happen to unemployment in the short run?

c.

What will happen to output and prices in the long run?

Answer

a.

In the short run, output would decrease with little change in prices.

b.

In the short run, unemployment will increase.

c.

In the long run, output will return to the full-employment level at a lower price level.

111.

An oil cartel effectively increases the price of oil by 100 percent, leading to an adverse supply shock in both Country A and Country B. Both countries were in long-run equilibrium at the same level of output and prices at the time of the shock. The central bank of Country A takes no stabilizing policy actions. After the short-run impacts of the adverse supply shock become apparent, the central bank of Country B increases the money supply to return the economy to full employment.

a.

Describe the short-run impact of the adverse supply shock on prices and output in each country.

b.

Compare the long-run impact of the adverse supply shock on prices and output in each country.

Answer

a.

In both Country A and Country B, output will decline and the price level will rise.

b.

In the long run, output in both Country A and Country B will return to the full-employment level, but the price level will be higher in Country B than in Country A because of the policy accommodation.

112.

An economy is initially in long-run equilibrium. The introduction of an electronic payments system dramatically reduces the demand for money in the economy.

a.

What is the short-run impact on prices and output of the new system?

b.

What can the central bank do, if anything, to counteract the short-run changes in output and prices?

c.

If the central bank does not take any policy actions, what will be the long-run impact of the electronic payments system on prices and output?

Answer

a.

In the short run, output will increase as the reduction in money demand (increase in velocity) shifts the aggregate demand curve out to the right. There will be an increase in output and little change in prices in the short run.

b.

The central bank could counteract the decline in money demand by reducing the money supply, shifting the aggregate demand curve back to the left.

c.

In the long run with no central bank stabilizing action, output will return to the full-employment level with a higher price level.

113.

Explain the meaning of monetary neutrality and illustrate graphically that there is monetary neutrality in the long run in the aggregate demand–aggregate supply model. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values. Explain in words what your graph illustrates.

Answer

Monetary neutrality is the property that changes in money do not change real variables. Graphically starting from long-run equilibrium at A, an increase in the money supply shifts the AD curve rightward. There is a short run equilibrium at B with higher real output, but in the long run, prices increase, shifting the SRAS upward until the new long-run equilibrium is reached at C, where there is a higher price level, but no change in real GDP. This illustrates that in the long-run the change in the money supply does not change the real variable (real GDP).

114.

You are given information about the following leading indicators. For each indicator explain whether the information suggests that a recession or expansion should be expected in the future.

a.

Average initial weekly claims for unemployment insurance rise.

b.

New building permits issued increases.

c.

The interest rate spread between the 10-year Treasury note and the 3-month Treasury bill narrows.

d.

The Index of Supplier Deliveries falls.

115.

Monetary policy can be either a stabilizing influence on the economy or a source of instability. Give an explanation for both possibilities.

Answer

If monetary policy is used to offset changes in aggregate demand that move an economy away from the natural rate, then monetary policy actions are stabilizing. If monetary policy actions move an economy away from the natural rate, either by increasing or decreasing the money supply when the economy is in long-run equilibrium, then monetary policy is destabilizing.

116.

How does recession occur? What is a business cycle?

Answer

When an economy experiences a period of falling output and rising unemployment, the economy is said to be in recession. The short-term fluctuations in employment and output are known as the business cycle

117.

What is the relationship between unemployment and real GDP? Explain Okun’s law.

Answer

GDP and unemployment have a negative relationship because employed workers help to produce goods and services while unemployed workers don’t. So increase in the unemployment rate is associated with decrease in real GDP. This negative relationship is called Okun’s law.

118.

What is the difference between the short run and the long run?

Answer

In the short run prices are sticky at some predetermined level because many prices do not respond to changes in monetary policy, while in the long run prices are flexible and are able to respond to the changes in supply or demand.

119.

What is aggregate demand? Why is the aggregate demand curve downward sloping?

Answer

Aggregate demand is the relationship between the aggregate price level and the quantity of output demanded. The aggregate demand curve slopes downward because the higher the price level (P), the lower the level of real balances (M/P), and therefore the lower the quantity of goods and services demanded (Y).

120.

According to the IS-LM model, what do an inward and outward shift in the aggregate demand curve mean?

Answer

An inward shift in the aggregate demand curve shows thst a decrease in the money supply (M) reduces the nominal value of output (PY). Thus, the reductions in the money supply shift the aggregate demand curve inward. Similarly, an increase in the money supply further increases the nominal value of output. As a result, the aggregate demand curve shifts outward.

121.

Explain aggregate supply. Why is the aggregate supply curve vertical in the long run and horizontal in the short run?

Answer

Aggregate supply is the relationship between the price level and quantity of goods and services supplied. As the firms that supply goods and services have flexible prices in the long run and sticky prices in the short run, the relationship depends on the time horizon.

According to the classical model, the output does not depend on the price level. So drawing a vertical aggregate supply curve means the intersection of the aggregate demand curve with this vertical aggregate supply curve determines the price level in the long run. It implies that the level of output is independent of the money supply.

In the short run prices are sticky to the price level, so the short run aggregate supply curve is horizontal. The short run equilibrium of the economy is the intersection of the aggregate demand curve and the horizontal short run aggregate supply curve.

122.

How does an economy make a transition from short run to long run?

Answer

Suppose that an economy is initially in the long run. There are three curves available: the aggregate demand curve, the long run aggregate supply curve, and short run aggregate supply curve. In the long run, the economy finds itself at the intersection of the long run aggregate supply curve and the aggregate demand curve. Because prices have also adjusted to this level, the short run aggregate supply curve intersects this point as well.

123.

Explain the concepts of shocks in aggregate demand and aggregate supply.

Answer

Changes in the aggregate demand and supply curves cause fluctuations in the economy as a whole. The exogenous events that create shifts in these curves are called shocks. A shock that shifts the aggregate demand curve is called demand shock, while a shock that shifts the aggregate supply curve is called a supply shock.

124.

What is stabilization policy?

Answer

The demand and supply shocks disrupt the economy by pushing output and employment away from their natural levels. The policy actions aimed at reducing the severity of short run economic fluctuations are called stabilization policy.

125.

Define the terms: i) adverse supply shocks, ii) favorable supply shocks.

Answer

i) An adverse supply shock is when events push costs and prices upward, for example, drought that destroys crops, an increase in union aggressiveness, etc.

ii) Favorable supply shocks are those that cause costs and prices to fall, for example, the break-up of an international oil cartel.