ECON 102: Macroeconomics HW 8 Solution

Adibah Abdulhadi Taehoon Kim Cici McNamaraSteven Zhang

March 7, 2017

HW8: Chapter 12 Problems: 1, 4, 6, 8, 10, 11, 12, 14, 15

12.1

A fall in the value of the dollar against other currencies makes U.S. final goodsand services cheaper to foreigners but does not affect the domestic aggregateprice level. Consequently, at every aggregate price level, aggregate output ishigher from a domestic perspective due to the increase in demand from foreignersfor U.S. exports. This manifests itself in a rightward shift in the aggregatedemand curve rather than a movement along the curve, so you are correct andyour study partner is wrong.

12.4

In the short run, the rise in the aggregate price level extends to everything exceptwages. This will increase firm’s profits, and aggregate output will increase fromY1 to Y2. However, in the long run, wages will rise as well, so the firm’s costswill increase, reducing profits and shifting the LRAS curve to the left back tolong-run equilibrium at the reduced level of output.

1

12.6

Ranked in order from most to least preferred:

1. positive supply shock: increases output while decreasing prices so thatthe shock causes neither inflation nor unemployment.

2. positive demand shock: increases output while raising prices, causinginflation but not unemployment. The consequences of the shock can beaddressed through either fiscal policy in the form of reduced spending orraised taxes or through monetary policy policy in the form of a reducedmoney supply.

3. negative demand shock: decreases output while lowering prices, causingunemployment but not inflation. The consequences of the shock can beaddressed through either fiscal policy in the form of increased spendingor tax cuts or through monetary policy in the form of an increase in themoney supply.

4. negative supply shock: reduces output while raising prices so that theshock causes both inflation and unemployment. The use of monetary orfiscal policy to shift the demand curve and address inflation will worsenunempoyment and vice versa.

2

12.8

The introduction of the computer operating system increases labor productivityand shifts the SRAS curve to the right. This will transition the economy fromone short-run equilibrium to another with a higher level of aggregate outputand lower aggregate price level.

3

12.10

12.10.a

12.10.b

An increase in the oil price is a negative supply shock: SRAS shifts to the left.

4

12.10.c

A drop in home prices is a negative demand shock: AD shifts to the left.

12.10.d

Both shocks reduced demand so that Y3 is unquestionably lower than Y1. How-ever, the supply shock raised the aggregate price level while the demand shocklowered it, so the total effect on the aggregate price level is indeterminate wi-htout knowing the relative sizes of the shocks.

12.11

12.11.a

A decrease in households’ wealth will result in a negative demand shock, shiftingthe aggregate demand curve to the left, decreasing the aggregate price level andaggregate output. In the short run, there will be a recessionary gap. In the longrun, wages will be renegotiated and lowered to account for the lower aggregateprice level, lowering firm’s costs and inducing a positve supply shock. This willshift the SRAS curve rightward so that it intersects aggregate demand and theLRAS curve, bringing us back to equilibrium at the same level of aggregateoutput but a lower aggregate price level.

5

12.11.b

A tax cut will result in a positive demand shock, shifting the aggregate demandcurve to the right, increasing the aggregate price level and aggregate output. Inthe short run, there will be an inflationary gap. In the long run, wages will berenegotiated to account for the higher aggregate price level, raising firm’s costsand inducing a negative supply shock. This will shift the SRAS curve leftwardso that it intersects aggregate demand and the LRAS curve, bringing us back toequilibrium at the same level of aggregate output but a higher aggregate pricelevel.

6

12.12

12.12.a

A tax increase will result in a negative demand shock, shifting the aggregatedemand curve to the left, decreasing the aggregate price level and aggregateoutput. In the short run, there will be an recessionary gap. In the long run,wages will be renegotiated to account for the lower aggregate price level, loweringfirm’s costs and inducing a positive supply shock. This will shift the SRAScurve rightward so that it intersects aggregate demand and the LRAS curve,bringing us back to equilibrium at the same level of aggregate output but alower aggregate price level.

7

12.12.b

An increase in the money supply will result in a positive demand shock, shiftingthe aggregate demand curve to the right, increasing the aggregate price leveland aggregate output. In the short run, there will be an inflationary gap. In thelong run, wages will be renegotiated to account for the higher aggregate pricelevel, raising firm’s costs and inducing a negative supply shock. This will shiftthe SRAS curve leftward so that it intersects aggregate demand and the LRAScurve, bringing us back to equilibrium at the same level of aggregate output buta higher aggregate price level.

8

12.14

12.14.a

The aggregate price level rose while aggregate output fell. This is known asstagflation.

12.14.b

To address the fall in aggregate output, the government could use either fiscalor monetary policy to induce a positive aggregate demand shock. This couldbe accomplished with monetary policy by increasing the money supply or withfiscal policy by either cutting taxes or increasing government spending. Whilethese polices address the fall in output, they exacerbate inflation even further.

9

To address the rise in aggregate prices the government could use either fiscalor monetary policy to induce a negative aggregate demand shock. This couldbe accomplished with monetary policy by decreasing the money supply or withfiscal policy by either raising taxes or decreasing government spending. Whilethese polices address the rise in prices, they exacerbate the fall in output evenfurther.

10

12.14.c

Supply shocks represent a dilemma for government policy makers because theycause aggregate output and prices to increase or decrease together. Becausepolicy makers have little power to shift the SRAS curve, their only tool inaffecting equilibrium is by shifting the aggregate demand curve, which can onlyaddress one economic malady at the expense of the other.

12.15

Increases in aggregate output accompanied by little or no changes in aggregateprices indicate rightward shifts of the SRAS, aggregate demand, and LRAScurves. Increases in worker productivity in the 1990s would have shifted boththe SRAS and LRAS curves to the right. Additionally, a strong stock marketwould have increased household wealth and shifted the aggregate demand curveto the right as well.

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