Chapter 10 - Real GDP and the Price Level in the Long Run.doc

144Miller• Economics Today, Nineteenth Edition Chapter 10Real GDP and the Price Level in the Long Run151 Answers to Questions for Critical Analysis China’s Long String of Rightward Shifts in Its LRAS Curve (p. 215) Has China’s production possibilities curve been shifting outward or inward over the past 40 years? Explain your answer. The long-run aggregate supply curve of China has been shifting rightward. This also means that China’s production possibilities curve has been shifting outward. Does the “Sentiment” of Consumers Generate Aggregate Demand Shifts? (pp. 219?220) Why do you suppose that economists generally are more interested in the Index of Consumer Sentiment’s validity than they are in its reliability as a predictor? If the Index of Consumer Sentiment’s validity as a predictor is doubtful, it is less useful as an indicator of actual spending that economists are interested in. Inferring That South African Aggregate Demand Dropped after 2008 (pp. 224) What would happen to the South African inflation rate in future years if the AD curve were to begin shifting rightward at a more rapid pace than the LRAS curve? If the South African AD curve were to begin shifting rightward at a more rapid pace than the LRAS curve, then the inflation rate in the future years would be higher. You Are There Watching a Crumbling U.S. River System Impede Growth of Aggregate Supply (p. 225) 1. As more of the nation’s systems of river locks become deficient, what is happening to the pace at which the U.S. production possibilities curve shifts outward over time? As more of the nation’s systems of river locks become deficient, the U.S. production possibilities curve will shift outward more slowly over time. 2. How are deficiencies in the U.S. river system affecting the extent to which the U.S. long-run aggregate supply come shifts rightward each year? Deficiencies in the U.S. river system will slow down the pace at which the U.S. long-run aggregate supply curve shifts rightward over time. Issues and Applications The Implications of U.S. Secular Stagnation for Real GDP and the Price Level (pp. 226–227) 1. How could a return of the U.S. population growth rate to its previous level reduce the disinflationary effect of secular stagnation? As the U.S. population growth rate returns to its previous level, the AD curve shifts rightward at a faster pace. The faster rightward shifts of the AD curve would reduce the disinflationary effect of secular stagnation. 2. Why might a return of the U.S. population growth rate to its prior level also tend to boost growth of U.S. long-run aggregate supply? (Hint: Recall that real GDP growth is generated by the contributions of growth in labor and capital and growth in productivity of these resources.)? A higher level of U.S. population growth results in more growth in labor, which in turn boosts growth of the nation’s long-run aggregate supply. Research Project 1. To read a “simple guide” to the interaction between secular stagnation and inflation, see the Web Links in MyEconLab. 2. Take a look at U.S. real GDP per capita in the Web Links in MyEconLab. Answers to Problems 10-1. Many economists view the natural rate of unemployment as the level observed when real GDP is given by the position of the long-run aggregate supply curve. How can there be positive unemployment in this situation? The amount of unemployment would be the sum of frictional and structural unemployment. 10-2. Suppose that the long-run aggregate supply curve is positioned at a real GDP level of $18 trillion in base-year dollars, and the long-run equilibrium price level (in index number form) is 115. What is the full-employment level of nominal GDP? $20.7 trillion 10-3. Continuing from Problem 10-2, suppose that the full-employment level of nominal GDP in the following year rises to $21.85 trillion. The long-run equilibrium price level, however, remains unchanged. By how much (in real dollars) has the long-run aggregate supply curve shifted to the right in the following year? By how much, if any, has the aggregate demand curve shifted to the right? (Hint: The equilibrium price level can stay the same only if LRAS and AD shift rightward by the same amount.) The real value of the new full-employment level of nominal GDP is ($21.85 trillion/1.15) = $19 trillion, so the long-run aggregate supply curve has shifted rightward by $1 trillion, in base-year dollars. 10-4. Suppose that the position of a nation’s long-run aggregate supply curve has not changed, but its long-run equilibrium price level has increased. Which of the following factors might account for this event? a. A rise in the value of the domestic currency relative to other world currencies b. An increase in the quantity of money in circulation c. An increase in the labor force participation rate d. A decrease in taxes e. A rise in real incomes of countries that are key trading partners of this nation f. Increased long-run economic growth b, d, and e 10-5. Identify the combined shifts in long-run aggregate supply and aggregate demand that could explain the following simultaneous occurrences. a. An increase in equilibrium real GDP and an increase in the equilibrium price level b. A decrease in equilibrium real GDP with no change in the equilibrium price level c. An increase in equilibrium real GDP with no change in the equilibrium price level d. A decrease in equilibrium real GDP and a decrease in the equilibrium price level a. A rightward shift of the LRAS curve coupled with a shift in the AD curve farther to the right b. A leftward shift of the LRAS curve coupled with a leftward shift of the AD curve of the same magnitude c. A rightward shift of the LRAS curve coupled with a rightward shift of the AD curve of the same magnitude d. A leftward shift of the LRAS curve coupled with a shift of the AD curve farther to the left 10-6. Suppose that during the past 3 years, equilibrium real GDP in a country rose steadily, from $450 billion to $500 billion, but even though the position of its aggregate demand curve remained unchanged, its equilibrium price level steadily declined, from 110 to 103. What could have accounted for these outcomes, and what is the term for the change in the price level experienced by this country? The LRAS curve has shifted rightward, and the consequent decline of the equilibrium price level is secular deflation. 10-7. Suppose that during a given year, the quantity of U.S. real GDP that can be produced in the long run rises from $17.9 trillion to $18.0 trillion, measured in base-year dollars. During the year, no change occurs in the various factors that influence aggregate demand. What will happen to the U.S. long-run equilibrium price level during this particular year? This change implies a rightward shift of the long-run aggregate supply curve along the unchanged aggregate demand curve, so the long-run equilibrium price level will decline. 10-8. Assume that the position of a nation’s aggregate demand curve has not changed, but the long-run equilibrium price level has declined. Other things being equal, which of the following factors might account for this event? a. An increase in labor productivity b. A decrease in the capital stock c. A decrease in the quantity of money in circulation e. The discovery of new mineral resources used to produce various goods f. A technological improvement a, d, and e 10-9. Suppose that there is a sudden rise in the price level. What will happen to economywide planned spending on purchases of goods and services? Why? There are three effects. First, there is a real-balance effect because the rise in the price level reduces real money balances, inducing people to cut back on their spending. In addition, there is an interest rate effect as a higher price level pushes up interest rates, thereby reducing the attractiveness of purchases of autos, houses, and plants and equipment. Finally, there is an open-economy effect as home residents respond to the higher price level by reducing purchases of domestically produced goods in favor of foreign-produced goods, while foreign residents cut back on their purchases of home-produced goods. All three effects entail a reduction in purchases of goods and services. 10-10. Assume that the economy is in long-run equilibrium with complete information and that input prices adjust rapidly to changes in the prices of goods and services. If there is a rise in the price level induced by an increase in aggregate demand, what happens to real GDP? If there is full information and rapid adjustment of input prices to the rise in the price level, then firms do not change their production plans. The increase in the price level leads to no change in real GDP. This is an upward movement along the vertical long-run aggregate supply curve. 10-11. Consider the diagram below when answering the questions that follow. a. Suppose that the current price level is P2. Explain why the price level will decline toward P1. b. Suppose that the current price level is P3. Explain why the price level will rise toward P1. a. At the price level P2 above the equilibrium price level P1, the total quantity of real goods and services that people plan to consume is less than the total quantity that is consistent with firms’ production plans. One reason is that at the higher-than-equilibrium price level, real money balances are lower, which reduces real wealth and induces lower planned consumption. Another is that interest rates are higher at the higher-than-equilibrium price level, which generates a cutback in consumption spending. Finally, at the higher-than-equilibrium price level P2, people tend to cut back on purchasing domestic goods in favor of foreign-produced goods, and foreign residents reduce purchases of domestic goods. As unsold inventories of output accumulate, the price level drops toward the equilibrium price level P1, which ultimately causes planned consumption to rise toward equality with total production. b. At the price level P3 below the equilibrium price level P1, the total quantity of real goods and services that people plan to consume exceeds the total quantity that is consistent with firms’ production plans. One reason is that at the lower-than-equilibrium price level, real money balances are higher, which raises real wealth and induces higher planned consumption. Another is that interest rates are lower at the lower-than-equilibrium price level, which generates an increase in consumption spending. Finally, at the lower-than-equilibrium price level P3, people tend to raise their purchases of domestic goods and cut back on buying foreign-produced goods, and foreign residents increase purchases of domestic goods. As inventories of output are depleted, the price level begins to rise toward the equilibrium price level P1, which ultimately causes planned consumption to fall toward equality with total production. 10-12. Explain whether each of the following events would cause a movement along or a shift in the position of the LRAS curve, other things being equal. In each case, explain the direction of the movement along the curve or shift in its position. a. Last year, businesses invested in new capital equipment, so this year the nation’s capital stock is higher than it was last year. b. There has been an 8 percent increase in the quantity of money in circulation that has shifted the AD curve. c. A hurricane of unprecedented strength has damaged oil rigs, factories, and ports all along the nation’s coast. d. Inflation has occurred during the past year as a result of rightward shifts of the AD curve. a. An increase in the capital stock causes real planned production to rise at any given price level, so the LRAS curve shifts rightward. b. An increase in the quantity of money causes the aggregate demand to shift rightward, which generates a movement upward along the LRAS curve. c. This reduction in the capital stock, which also will lead to higher energy prices, causes real planned production to decline at any given price level, so the LRAS curve shifts leftward. d. When the price level rises, there is a movement of the AD curve upward along the LRAS curve. 10-13. Explain whether each of the following events would cause a movement along or a shift in the AD curve, other things being equal. In each case, explain the direction of the movement along the curve or shift in its position. a. Deflation has occurred during the past year. b. Real GDP levels of all the nation’s major trading partners have declined. c. There has been a decline in the foreign exchange value of the nation’s currency. d. The price level has increased this year. a. When the price level falls, there is a movement downward along the AD curve. b. The decline in foreign real GDP levels reduces incomes of foreign residents, who cut back on their spending on domestic exports. Thus, the domestic AD curve shifts leftward. c. The fall in the foreign exchange value of the nation’s currency makes domestic-produced goods and services less expensive to foreign residents, who increase their spending on domestic exports. Thus, the domestic AD curve shifts rightward. d. An increase in the price level causes a movement upward along the AD curve. 10-14. This year, a nation’s long-run equilibrium real GDP and price level both increased. Which of the following combinations of factors might simultaneously account for both occurrences? a. An isolated earthquake at the beginning of the year destroyed part of the nation’s capital stock, and the nation’s government significantly reduced its purchases of goods and services. b. There was a technological improvement at the end of the previous year, and the quantity of money in circulation rose significantly during the year. c. Labor productivity increased throughout the year, and consumers significantly increased their total planned purchases of goods and services. d. The capital stock increased somewhat during the year, and the quantity of money in circulation declined considerably. b and c 10-15. Explain how, if at all, each of the following events would affect equilibrium real GDP and the long-run equilibrium price level. a. A reduction in the quantity of money in circulation b. An income tax rebate (the return of previously paid taxes) from the government to households, which they can apply only to purchases of goods and services c. A technological improvement d. A decrease in the value of the home currency in terms of the currencies of other nations a. The aggregate demand curve shifts leftward along the long-run aggregate supply curve; the equilibrium price level falls, and equilibrium real GDP remains unchanged. b. The aggregate demand curve shifts rightward along the long-run aggregate supply curve; the equilibrium price level rises, and equilibrium real GDP remains unchanged. c. The long-run aggregate supply curve shifts rightward along the aggregate demand curve; the equilibrium price level falls, and equilibrium real GDP increases. d. The aggregate demand curve shifts rightward along the long-run aggregate supply curve; the equilibrium price level rises, and equilibrium real GDP remains unchanged. 10-16. For each question, suppose that the economy begins at the long-run equilibrium point A in the diagram below. Identify which of the other points on the diagram—points B, C, D, or E—could represent a new long-run equilibrium after the described events take place and move the economy away from point A. a. Significant productivity improvements occur, and the quantity of money in circulation increases. b. No new capital investment takes place, and a fraction of the existing capital stock depreciates and becomes unusable. At the same time, the government imposes a large tax increase on the nation’s households. c. More efficient techniques for producing goods and services are adopted throughout the economy at the same time that the government reduces its spending on goods and services. a. B: Productivity improvements cause the LRAS curve to shift rightward, from LRAS1 to LRAS2, and the increase in the quantity of money in circulation causes the AD curve to shift rightward, from AD1 to AD2. b. C: The reduction in the usable portion of the capital stock reduces the economy’s long-run productive capabilities, so the LRAS curve shifts leftward, from LRAS1 to LRAS3. The increase in taxes imposed on households induces them to reduce their expenditures, so the AD curve shifts leftward, from AD1 to AD3. c. E: The technological improvement shifts the LRAS curve rightward, from LRAS1 to LRAS2, and the reduction in government spending shifts the AD curve leftward, from AD1 to AD3. 10-17. In Ciudad Barrios, El Salvador, the latest payments from relatives working in the United States have finally arrived. When the credit unions open for business, up to 150 people are already waiting in line. After receiving the funds their relatives have transmitted to these institutions, customers go off to outdoor markets to stock up on food or clothing or to appliance stores to purchase new stereos or televisions. Similar scenes occur throughout the developing world, as each year migrants working in higher-income, developed nations send around $200 billion of their earnings back to their relatives in less developed nations. Evidence indicates that the relatives, such as those in Ciudad Barrios, typically spend nearly all of the funds on current consumption. a. Based on the information supplied, are developing countries’ income inflows transmitted by migrant workers primarily affecting their economies’ long-run aggregate supply curves or aggregate demand curves? b. How are equilibrium price levels in nations that are recipients of large inflows of funds from migrants likely to be affected? Explain your reasoning. a. The income flows are mainly influencing relatives’ consumption, so the main effect is on the aggregate demand curve. b. A rise in aggregate demand will lead to an increase in the equilibrium price level. 10-18. In Figure 10-2, if the economy acquires a larger amount of capital goods in the current year, does a larger or smaller onward shift in the production possibilities curve result? Does the LRAS curve shift more or less far to the right? Why? The acquisition of a larger amount of capital goods in the current year enables production of more of all types of goods and services in future years. Consequently, the production possibilities curve shifts a farther distance outward, and there is a greater rightward shift of the LRAS curve. 10-19. Consider Figure 10-4, what are the three effects of decreases in the price level, and do these generate upwards or downward movements along the economy’s aggregate demand curve? Decreases in the price level bring about a real-balance effect, because the resulting increases in the real value of money holdings induce people to boost spending. Lower price levels also reduce the interest rate, which gives people an incentive to borrow more and spend more. Finally, lower price levels at home induce people to cut back on spending abroad and to spend more domestically. Taken together, total planned expenditures rise, so there is a downward movement along the AD curve. 10-20. Take a look at panel (a) of Figure 10-6. In the absence of a change in aggregate demand, what effect does economic growth have on the price level over time, other things being equal? Why? Economic growth entails rightward shifts in the position of the long-run aggregate supply curve over time, which generates equilibrium points to the right and lower along the stationary aggregate demand curve. Hence, the price level declines, and secular deflation occurs. 10-21. Take a look at panel (b) of Figure 10-6. If the Federal Reserve seeks to prevent secular deflation from taking place as a consequence of economic growth, how should it change the quantity of money in circulation? How would this policy action prevent secular deflation? Rightward shifts of the LRAS curve accompanying economic growth would, in the absence of a Fed policy action, yield new equilibrium points lower down along the aggregate demand curve. Hence, the price level would tend to fall. Appropriate increases in the quantity of money in circulation would shift the AD curve rightward and would keep the price level from falling and thereby prevent secular deflation. 10-22. Consider panel (a) of Figure 10-8. What type of variation in the position of the long-run aggregate supply curve could generate inflation-that is, an increase in the equilibrium, price level? In a nation that generally experiences economic growth over the long run, would we anticipate that such a change in the position of the long-run aggregate supply curve could explain persistent inflation? Leftward shifts in the position of the LRAS curve, which might be caused by drops in labor force participation or higher marginal income tax rates, bring about in a higher equilibrium price level and, hence, inflation. In an economy that generally experiences economic growth over the long run, such leftward shifts must be short-lived and consequently could not explain persistent inflation. 10-23. Take a look at panel (b) of Figure 10-8. What change in the position of the aggregate demand curve could generate inflation-that is, an increase in the equilibrium price level? What type of variation in the quantity of money placed into circulation by the Federal Reserve could generate such a change in the position of the aggregate demand curve? Rightward shifts in the position of the AD curve would generate a higher price level and, hence, inflation. Persistent increases in the quantity of money in circulation by the Fed could generate such shifts and thereby could explain persistent inflation. Selected References Barro, Robert J., Macroeconomics, 2nd ed., New York: John Wiley and Sons, 1987. Dornbush, Rudiger and Stanley Fischer, Macroeconomics, 4th ed., New York: McGraw-Hill, 1987. Friedman, Milton, “Nobel Lecture: Inflation and Unemployment,” Journal of Political Economy, Vol. 85, 1977, pp. 451–471. Miller, Roger L. and Robert Pulsinelli, Macroeconomics, New York: Harper and Row, 1986.