Question 2

8. Economic fluctuations I The following graph shows a hypothetical economy in long-run equilibrium at an expected price level of 120 and a natural output level of $300 billion. Suppose a stock market boom increases household wealth and causes consumers to spend more. Using the graph, shift the short-run aggregate supply (AS) curve or the aggregate demand (AD) curve to show the short-run impact of the stock market boom. 240 O AS 200 AD 160 AS PRICE LEVEL 120 80 AD 40 100 200 300 400 500 600 OUTPUT (Billions of dollars)In the short run, the increase in consumption spending associated with the stock market expansion causes the price level to w the price level people expected and the quantity of output to w the natural level of output. The stock market boom will cause the unemployment rate to w the natural rate of unemployment in the short run. Again, the following graph shows a hypothetical economy experiencing long-run equilibrium at the expected price level of 120 and natural output level of 300 billion, prior to the increase in consumption spending associated with the stock market expansion. Along the transition from the short run to the long run, price-level expectations will w and the w curve will shift to the w . Using the graph, illustrate the long-run impact of the stock market boom by shifting both the aggregate demand (AD) curve and the short-run aggregate supply (AS) curve in the appropriate directions. @ Q AD u _, AS L == Y L o T o 0 100 200 300 400 500 600 QUTPUT (Billions of dollars) In the long run, due to the stock market boom, the price level w |, the quantity of output w the natural level of output, and the unemployment rate w the natural rate. TR ey 2. Explaining short-run economic fluctuations A majority of economists believe that in the long run, real economic variables and nominal economic variables behave independently of one another. For example, an increase in the money supply, a variable, will cause the price level, a variable, to increase but will have no long-run effect on the quantity of goods and services the economy can produce, a variable. The notion that an increase in the quantity of money will impact the price level but not the output level is known as However, in the short run, most economists believe that real and nominal variables are intertwined. Economists use the model of aggregate demand and aggregate supply to examine the economy's short-run fluctuations around the long-run output level. The following graph shows an incomplete short-run aggregate demand (AD) and aggregate supply (AS) diagram-it needs appropriate labels for the axes and curves. In the questions that follow you will identify some of the missing labels. (?) AS VERTICAL AXIS AL HORIZONTAL AXIS The aggregate curve shows the quantity of goods and services that firms produce and sell at each price level. The horizontal axis of the aggregate demand and aggregate supply model measures the overall6. Why the aggregate supply curve slopes upward in the short run In the short run, the quantity of output supplied by firms can deviate from the natural level of output if the actual price level deviates from the expected price level in the economy. A number of theories explain reasons why this might happen. For example, the misperceptions theory asserts that changes in the price level can temporarily mislead firms about what is happening to their output prices. Consider a soybean farmer who expects a price level of 100 in the coming year. If the actual price level turns out to be 90, soybean prices will W , and if the farmer mistakenly assumes that the price of soybeans declined relative to other prices of goods and services, she will respond by W the quantity of soybeans supplied. If other producers in this economy mistake changes in the price level for changes in their relative prices, the unexpected decrease in the price level causes the quantity of output supplied to W the natural level of output in the short run. Suppose the economy's short-run aggregate supply (AS) curve is given by the following equation: Quantity of Qutput Supplied = Natural Level of Output + a x (Price Level gqya Price Level prpected) The Greek letter & represents a number that determines how much output responds to unexpected changes in the price level. In this case, assume that & = $2 billion. That is, when the actual price level exceeds the expected price level by 1, the quantity of output supplied will exceed the natural level of output by $2 billion. Suppose the natural level of output is $50 billion of real GDP and that people expect a price level of 100. On the following graph, use the purple line {diamond symbol) to plot this economy's long-run aggregate supply (LRAS) curve. Then use the orange line segments (square symbol) to plot the economy's short-run aggregate supply (A5) curve at each of the following price levels: 80, 95, 100, 105, and 110. 126 T 120 + 115 -+ 110 + : 1056 -+ LRAS 100 + FRICE LEWEL o0 0 0 20 30 40 50 60 70 &80 80 100 QUTPUT (Billions of dollars) The short-run quantity of output supplied by firms will fall short of the natural level of output when the actual price level w the price level that people expected