ELS Chapter 13: Graphing Exercise Answers

ELS Chapter 13: Graphing Exercise Answers
Using the aggregate demand – aggregate supply model
1.	Oil prices rose dramatically during the 1970s, creating an adverse inflation shock. Analyze the effects of higher oil prices on the economy. What happens in the short run to inflation, output, and the unemployment rate as a consequence of the increase in oil prices?
	answer: An adverse inflation shock shifts the SRAS curve up. In the short run the economy will move to the intersection of the AD and SRAS curve (at p' and Y'). The inflation rate rises, output falls, the economy experiences a recessionary gap, and the unemployment rate rises (recall Okun's Law).
2.	Suppose there is an adverse inflation shock in the economy. If there are no changes in monetary or fiscal policy, what will happen to inflation and output over time (in the long run)? If the Federal Reserve and the government respond to the inflation shock by changing monetary and fiscal policies to eliminate the resulting output gap, what will happen to inflation and output over time? Use your results to explain why inflation shocks pose a difficult dilemma for macroeconomic policymakers.
	answer: An adverse inflation shock shifts the SRAS curve up. In the short run the economy will move to the intersection of the AD and SRAS curve (at p' and Y'), creating a recessionary gap. Because of the recessionary gap, eventually inflation would begin to drift downward, shifting the SRAS curve down until the recessionary gap is eliminated. Inflation stops declining when long-run equilibrium is restored, back at the original inflation rate and at potential GDP. Instead of letting the economy correct itself over time, policymakers could take active steps to eliminate the recessionary gap - increasing AD by reducing taxes, increasing government spending, or reducing the real interest rate. This will shift the AD curve to the right until AD intersects both the SRAS and LRAS curves at potential GDP. In this case the inflation rate is higher than in the original equilibrium but the output level and the unemployment rate are the same as in the original equilibrium. In the first case, both the output gap and the increase in inflation would eventually be eliminated but it would put the economy through a long recession. In the second case, the output gap is eliminated more quickly, but the inflation rate would be higher. Thus, policymakers have to choose between a longer recession and higher inflation when making their policy decision.
3.	During the late 1990s the U.S. economy was booming due to an increase in consumer and business spending: output was at or beyond potential GDP and unemployment rates were falling to 30-year lows. How should the Federal Reserve respond in this type of situation?
	answer: The booming economy is represented by a shift to the right in the AD curve. In the short run, real GDP will increase to Y', while inflation remains steady. If the Federal Reserve followed a "do-nothing" approach, the SRAS would drift upward over time and the economy would return to potential output but at a higher inflation rate. If the Federal Reserve instead raised interest rates, this would cause the AD curve to shift back to the left until it intersected the SRAS curve at Y*. In this case, output returns to potential while the inflation rate remains unchanged. Clearly, the latter policy is better, and this is the course of action actually followed by the Federal Reserve in mid-1999 in hopes of slowing down a potentially overheating economy.
4.	The latest U.S. recession began in March, 2001, primarily due to a reduction in investment spending by businesses. According to the AD/SRAS/LRAS model, what are the short-term effects of a decline in investment spending? How should policymakers like the Federal Reserve, Congress, and the President respond to this type of change in autonomous spending?
	answer: A reduction in investment spending by businesses is illustrated by a leftward shift in the AD curve, resulting in a recessionary gap and no change in inflation in the short run. If policymakers choose not to respond, the SRAS would drift downward over time and the economy would return to potential output at a lower rate of inflation. However, this may take a long time; in the meantime the economy is suffering from a recession - in particular, increased unemployment rates and a level of real GDP below potential GDP. Policymakers can reduce unemployment rates and increase real output by attempting to increase AD - the Federal Reserve can lower interest rates or Congress and the President can boost government spending or lower taxes. Each of these would boost overall planned aggregate expenditures and increase the equilibrium level of real GDP - without raising the inflation rate (although it will be higher than if they had waited for the economy to adjust on its own).
5.	According to the AD/SRAS/LRAS model, what causes rising inflation? How would you illustrate this using the model?
	answer: Generally speaking, inflation rises for one of three reasons: (1) excessive aggregate spending, (2) inflation shocks, and (3) negative shocks to potential GDP. In the first case, excessive aggregate spending shifts the AD curve to the right. Without any intervention, the SRAS curve shifts up over time, leading the Federal Reserve to raise interest rates, leading to a reduction in spending and a move back along the AD to potential GDP (but at a higher inflation rate). In the second case, a negative inflation shock (such as an increase in energy prices) shifts the SRAS curve upward, leading to a recessionary gap with higher inflation. In the third case, the LRAS shifts to the left, causing an expansionary gap (potential output > actual output). Like the first case, this leads to an upward shift in the SRAS curve and a movement back along the AD curve to potential GDP (but at a higher inflation rate).
6.	Use the AD/SRAS/LRAS model to explain how a sustained decline in aggregate spending could lead to disinflation - a substantial and ongoing reduction in the rate of inflation - something the Federal Reserve became concerned about in the spring of 2003.
	Answer: A decline in aggregate spending shifts the AD curve to the left, creating a recessionary gap. If sustained, this output gap will lead suppliers to reduce the size of price increases or even reduce prices, causing a reduction in inflation rates and shifting the SRAS curve downward. The Federal Reserve responds to the decline in inflation by reducing interest rates, which should raise the equilibrium level of spending in the economy, moving the economy back toward potential GDP along the AD curve. As Economic Naturalist 28.5/15.5 points out, however, if interest rates are already low and aggregate spending remains weak, the Federal Reserve may not be able to reduce interest rates enough (they can't go lower than 0%) to boost the economy further, keeping the economy from reaching potential GDP.
7.	Worker productivity increased significantly in the mid/late 1990s, a point made publicly on numerous occasions by Federal Reserve chairman Alan Greenspan. Use the AD/SRAS/LRAS model to illustrate the effects on inflation and output of a permanent increase in labor productivity that reduces the cost of production.
	answer: As Economic Naturalist 28.3/15.3 indicates, an increase in labor productivity shifts the LRAS curve to the right, creating an output gap that leads to a decline in inflation, a downward shift of the SRAS curve over time, and a movement to potential GDP along the AD curve.