Seminar Solutions: Week 17
L.A. Buchanan-Hodgman
February 28, 2016
17
Questions
17.1
Economic Concepts
Question:
Write a very short summary, using diagrams if appropriate, of the following concepts: inflationary output gap; recessionary output gap; adjustment to an inflationary output gap; long run aggregate supply; long run equilibrium; the Phillips curve; long-run Phillips curve.
Answer:
Inflationary output gapoccurs when, at the long-run macroeconomic equi-librium, there is a positive demand shock which shifts AD. The AD moves along the SRAS curve to a higher{P, Y}pair. As the short-run macroeconomic equi-librium AD1 = SRAS0 >LRAS0, this yields us a positive output gap. As the
positive output gap came about because of an positive AD shock, this is also inflationary (i.e., prices have risen).
Adjustment to an inflationary output gapcan come about by three main channels. First, the AD curve can shift to close the output gap by anatural
contraction in private sector demand - i.e., declining consumption, investment, exports or a rise in imports. Second, government could actively run contrac-tionary fiscal policies - i.e., increasing taxation or reducing spending. And third, the SRAS could shift to close the gap through higher factor pricesusually
through tightness in labour market conditions. In the case of the shift in AD, the gap is closed and the price level falls back to the initial point. In the case of a shift in the SRAS, the price level increase as the gap closes.
Long-run aggregate supplytells us about the potential quantity of real GDP attainable in the long-run and is vertical at this point. At the LRAS curve, all factor prices have fully adjusted. Shifts in long-run aggregate supply can come about by an increase in quality or quantity of the factors of production, or due to a permanent increase in productivity. Shifts to the right express economic growth, while shifts to the left express economic regress. Notice that shocks to AD only impact the price level in the long-run due to the shape of the LRAS curve.
17.2
True/False/Depends
Question:
1. Output gaps will lead to changes in both output and input prices.
DEPENDS
2. Long run aggregate supply is a horizontal line because firms will supply what is demanded at any given price level. FALSE
3. Long run equilibrium is determined solely by conditions of supply in the economy. TRUE
4. Economic growth requires continual increases in long run aggregate supply.
TRUE
5. Negative GDP gaps are associated with increasing negative inflation rates.
DEPENDS
17.3
Problem
Question:
Suppose the aggregate demand (AD) relationship is given by the linear relation-ship,P = 250−1.5Y and that the short-run aggregate supply (SRAS) is given by the linear relationship,P = 50+0.5Y, where P is the GDP deflator, an index number, and Y is real GDP in units of 10bn: (a) work out the macroeconomic equilibrium in terms of P and Y; sketch the relationships and equilibrium on a diagram and interpret your answer; (b) suppose you are told that potential real GDP is 1,000bn, then add this information to your diagram and comment on the implications; (c) suppose there is a positive aggregate demand shock and the AD relationship is nowP = 260−1.5Y, work out the new macroeconomic equilibrium, update your diagram, and comment on the potential implications of this demand shock.
Answer:
AD:P = 250−1.5Y (17.1)
SRAS:P = 50 + 0.5Y (17.2) Therefore (at short-run macroeconomics equilibrium);
AD=SRAS=⇒250−1.5Y = 50 + 0.5Y (17.3) 200 = 2Y (17.4)
Y = 100 (17.5)
So our equilibrium price level, in index form, is 100 and quantity of real GDP is£1,000bn. Which is equal to the LRAS, and therefore we are at the long-run
equilibrium. ForP = 260−1.5Y;
AD:P = 260−1.5Y (17.8)
SRAS:P = 50 + 0.5Y (17.9)
Therefore (at short-run macroeconomics equilibrium);
AD=SRAS=⇒260−1.5Y = 50 + 0.5Y (17.10) 210 = 2Y (17.11)
Y = 105 (17.12)
AD:P = 260−1.5Y = 260−1.5(105) = 102.5 (17.13)
SRAS:P = 50 + 0.5Y = 50 + 0.5(105) = 102.5 (17.14)
Therefore, we have a positive (inflationary) output gap which can be seen from the graph below - if you look closely enough that is!
17.4
Questions for Discussion
1. Starting with an economy at potential output, explain what happens to the price level and real GDP in the short run and the long run in response to (a) an increase in export demand, and (b) an increase in oil prices. 2. Why is the LRAS curve vertical? What does this imply about the impact
of aggregate demand shocks on equilibrium real GDP?
Answers:
1. An increase in export demand - X in the AD equation - acts to increase net exports and shifts the AD schedule, moving us from an initial (long-run) equilibrium, up the SRAS curve to the new (short-(long-run) equilibrium. At this point, output is above potential output and we have an positive (inflationary) output gap. As our short-run equilibrium (AD=SRAS) is above the LRAS curve - this is not a long-run equilibrium. Three things can now occur to close this gap. First, private sector demand could fall. Second, government could enact contractionary fiscal policy. And third, factor prices could rise due to inflationary pressures. If the first two occur, we arrive back at the LRAS at our initial price level. If the latter occurs, we arrive back at potential output but with a higher price level.
An increase in oil prices acts to increase firms costs and shifts the SRAS schedule, moving us from an initial (long-run) equilibrium, up the AD curve to the new (short-run) equilibrium. At this point, output is lower than potential output and we have an negative (recessionary) output gap. As our short-run equilibrium (AD=SRAS) is below the LRAS curve - this is not a long-run equilibrium. Three things can now occur to close this gap. First, private sector demand could increase. Second, government could enact expansionary fiscal policy. And third, factor prices could adjust back. If the first two occur, we arrive back at the LRAS but at a higher price level. If the latter occurs, we arrive back at potential output at the initial price level.
2. See the lecture and above for why it is vertical. Regarding the impact of demand shocks, the shape of the LRAS curve implies that, in the long-run, these only lead to higher/lower price levels with no permanent impact on the quantity of real GDP. The implications for government policy because of this are self evident.
