Long-Run vs Short-Run
Homework 4
Economics 503
Foundations of Economic Analysis
Assigned: Week 4
Due: Week 5
1. Using aggregate demand, short-run aggregate supply and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output? a. There is a decrease in households’ wealth due to a decline in the stock market. The model starts at point 1. Household consumption drops as wealth declines. This decreases spending at any given price level (the AD curve shifts in) and reduces the prices they are willing to pay for goods. The falling price level along with given wages raises the costs of hiring workers and output declines in equilibrium. Equilibrium price and output drop to point 2. The falling price level combined with fixed wages will raise the relative or real wage as the economy goes into a recession. The relatively low demand for labor in the recession will put downward pressure on the nominal wage rate. The falling cost of production reduces the prices that firms demand for their production (i.e the SRAS curve shifts down). Wages will fall until the labor market equilibrium return relative wages to their long-term levels. The new long run equilibrium will be at point 3. [pic]
b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases. The economy begins at point 1. When households have more disposable income, they increase spending. This shifts out demand for goods and increases the prices they are willing to pay for goods. The higher prices of goods reduce the cost of labor. Falling real wages induce firms to increase production. The new equilibrium is at point 2. When firms are producing a lot of output, labor demand is
Economics 503
Foundations of Economic Analysis
Assigned: Week 4
Due: Week 5
1. Using aggregate demand, short-run aggregate supply and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output? a. There is a decrease in households’ wealth due to a decline in the stock market. The model starts at point 1. Household consumption drops as wealth declines. This decreases spending at any given price level (the AD curve shifts in) and reduces the prices they are willing to pay for goods. The falling price level along with given wages raises the costs of hiring workers and output declines in equilibrium. Equilibrium price and output drop to point 2. The falling price level combined with fixed wages will raise the relative or real wage as the economy goes into a recession. The relatively low demand for labor in the recession will put downward pressure on the nominal wage rate. The falling cost of production reduces the prices that firms demand for their production (i.e the SRAS curve shifts down). Wages will fall until the labor market equilibrium return relative wages to their long-term levels. The new long run equilibrium will be at point 3. [pic]
b. The government lowers taxes, leaving households with more disposable income, with no corresponding reduction in government purchases. The economy begins at point 1. When households have more disposable income, they increase spending. This shifts out demand for goods and increases the prices they are willing to pay for goods. The higher prices of goods reduce the cost of labor. Falling real wages induce firms to increase production. The new equilibrium is at point 2. When firms are producing a lot of output, labor demand is