Deck 10: Bringing in the Supply Side: Unemployment and Inflation

Question 1

Explain why a decrease in the price of foreign oil shifts the aggregate supply curve outward to the right. What are the consequences of such a shift

Answer 1

Aggregate supply curve
The aggregate supply curve shows the total supply of output in an economy at a given price level during a period of time.
Reasons for outward shift in aggregate supply curve
Since the imported oil price decreases, it leads to a decrease in the production cost, which in turn increases the production. Because when the production cost decreases, it leads to an increase in profit. This profit induces the producers to produce more, which in turn increases the supply. This increase in supply shifts the aggregate supply curve outward to the right.
Consequences of the outward shift in aggregate supply curve
The outward shift of the aggregate supply curve is caused by increasing supply. The increase in supply reduces the price level and increases the output, income level, and employment.

Question 2

In an economy with the following aggregate demand and aggregate supply schedules, find the equilibrium levels of real output and the price level. Graph your solution. If full employment comes at $2,800 billion, is there an inflationary or a recessionary gap

Answer 2

Recessionary Gap
Recessionary gap arises when aggregate demand is lower than the aggregate supply and short run equilibrium in the economy is below the full employment level.
Graphical Representation
The following figure shows whether the economy has inflationary or recessionary gap.
Figure-2
In the above figure, X axis represents the different levels of output and Y axis represents the different levels of price. Here, the upward sloping curve is a supply curve and downward sloping curve is a demand curve.
Figure (2) clearly indicates that there exists an inflationary gap when the full employment level of output is $2,800. This is because the equilibrium level of output $3,000 is greater than the full employment level of output $2,800.

Question 3

Comment on the following statement: "Inflationary and recessionary gaps are nothing to worry about because the economy has a built-in mechanism that cures either type of gap automatically."

Answer 3

Recessionary gap
Recessionary gap arises when aggregate demand is lower and short-run equilibrium in an economy is below full employment level.
This problem leads to a fall in the nominal wages, which decreases the business costs. Decrease in business cost reduces the price level, thereby leading to deflation. Deflation causes recession in an economy. This deflationary situation increases the consumer's purchasing power and the net exports of the economy, which leads to a reduction in the recessionary gap. Hence, recession gap closes automatically.

Question 4

Suppose a worker receives a wage of $20 per hour. Compute the real wage (money wage deflated by the price index) corresponding to each of the following possible price levels: 85, 95, 100, 110, 120. What do you notice about the relationship between the real wage and the price level Relate your finding to the slope of the aggregate supply curve.

Question 5

Give two different explanations of how the economy can suffer from stagflation.

Question 6

Add the aggregate supply and demand schedules below to the example in Test Yourself Question 1 of Chapter 9 (page₁92) to see how inflation affects the multiplier.

Draw these schedules on a piece of graph paper.
a. Notice that the difference between columns (2) and (3), which show the aggregate demand schedule at two different levels of investment, is always $200. Discuss how this constant gap of $200 relates to your answer in the previous chapter.
b. Find the equilibrium GDP and the equilibrium price level both before and after the increase in investment. What is the value of the multiplier Compare that to the multiplier you found in Test Yourself Question 2 of Chapter 9.
Reference Question 1 of Chapter 9
Suppose exports and imports of a country are given by the following:

Reference Question 2 of Chapter 9
If domestic expenditure (the sum of C + I + G in the economy described in Test Yourself Question 1) is as shown in the following table, construct a 45° line diagram and locate the equilibrium level of GDP.

Question 7

Why do you think wages tend to be rigid in the downward direction

Question 8

Use an aggregate supply-and-demand diagram to show that multiplier effects are smaller when the aggregate supply curve is steeper. Which case gives rise to more inflation-the steep aggregate supply curve or the flat one What happens to the multiplier if the aggregate supply curve is vertical

Question 9

Explain in words why rising prices reduce the multiplier effect of an autonomous increase in aggregate demand.