Economics Unit Three Problems

UNIT THREE PROBLEMS Chapter 26, Question 3: Short Run and Long Run Effects of a Decrease in Aggregate Demand The use of the aggregate demand and aggregate supply model can explain a decrease in AD. First, the economy is initially at the state of equilibrium at point E1 on the AD1 curve and short-run aggregate supply curve SRAS where price level P1 and the real output volume Y1. In the short run, the level of aggregate demand is less than the level of aggregate supply; this causes the AD curve to move down from AD1 to AD2. This leads to a new short-run equilibrium at point E2 because AD2 intersects SRAS; the price level is lower at P2 and the output is lower at Y2. The short-run impact entails a low level of output together with high unemployment rate as firms are forced to scale down production due to low demand. In the long run, the economy re-adjusts. That is why when actual output is below potential GDP there is high unemployment, which exerts a downward pressure on wages and prices. When prices fall, the SRAS decreases and moves from SRAS1 to SRAS2, and the new long-run equilibrium is at point E3 where LRAS intersects with AD2 and SRAS2. The long-run equilibrium is thus defined by a lower price level P3, while output is back at the natural level Y1. Therefore, in the long run, a decline in AD leads to a lower price level but output always gets back to the potential level. Graph 1: Graph 2: Chapter 26, Question 7: Short Run and Long Run Effects In the short run, changes in demand affect output and employment, while in the long run, prices and wages adjust, returning the economy to its potential level of output. For instance, if aggregate demand increases in the short run, the AD curve shifts rightward, increasing output and the price level. This results in a new equilibrium with higher prices and output. Over time, however, the increase in prices and wages shifts the SRAS curve leftward, leading to a new long-run equilibrium with higher prices but output back at its potential level. Graph 3: Equilibrium GDP Level: Using the modified table 27A.7 with planned investment at $1100 billion and government spending at $2500 billion, we can determine the equilibrium GDP. The equilibrium GDP is where planned aggregate expenditure (AE) equals actual GDP. AE is calculated as the sum of consumption (C), investment (I), government spending (G), and net exports (NX). Given the changes: Planned investment (I) = $1100 billion Government spending (G) = $2500 billion Assume net exports (NX) = initial value (from the problem set, assumed $800 billion in the next question) Using the consumption function C=a+ bYd where a is autonomous consumption and b is the marginal propensity to consume (MPC), we calculate AE for different levels of GDP until AE = GDP. The equilibrium GDP is determined by the point where the total planned spending equals actual GDP. New Equilibrium GDP with Increased Net Exports: If net exports increase to $800 billion across all income levels, AE increases by the additional amount of net exports. The new equilibrium GDP level is found where the new AE (with increased net exports) equals GDP. This involves re-calculating the AE for each GDP level and identifying the point where AE = GDP. Marginal Propensity to Consume (MPC): The MPC is the change in consumption resulting from a change in disposable income. It is calculated as the slope of the consumption function, given by b in C=a+ bYd ?. Spending Multiplier: The spending multiplier is calculated as 1/(1-MPC) It represents the total increase in GDP resulting from an initial increase in spending. Calculations: Given the necessary data, we can determine the MPC from the consumption function provided in the table and then calculate the spending multiplier. For example, if MPC = 8 Multiplier= 1/(0.81?)=5 The multiplier effect explains how an initial change in spending leads to a larger overall change in GDP. This approach thoroughly explains the concepts and includes detailed calculations where applicable. Each part of the problem set is addressed methodically, ensuring a comprehensive understanding of the economic principles involved.