3. Using the Aggregate Demand/ Aggregate Supply framework, determine both i) the
ID: 1104635 • Letter: 3
Question
3. Using the Aggregate Demand/ Aggregate Supply framework, determine both i) the short run effect on the price level and real output and ii) the long run effect on the price level and real output ii) the total effect of the policy on the price level and real output for each of the following events (that is, do both parts () through (ii) for each of a through d.): a. Consumer confidence in the economic outlook increases. b. Govenment spending on Medicare payments for patient medical care decreases c. Workers obtain large wage increases. d. A new gasoline additive improves fuel economy in automobile engines by 25%.Explanation / Answer
a) Increased consumer confidence, shifts the AD curve to the right and in the short run price level and real output increases. During the transition from short to long run run, increased price level reduces real wage and so in the long run firms reduce nominal wage so that real wages are unchanged. Lower nominal wages reduces supply of labor so aggregate supply is reduced and shifts to the left. This increases the price further but brings the real output back to its level of full employment. Hence in total, price level rises multifold and output does not change
b) Lower government expenditure shifts the AD curve to the left and in the short run price level and real output decreases. During the transition from short to long run run, decreased price level increases real wage and so in the long run firms increase nominal wage so that real wages are unchanged.Higher nominal wages increases supply of labor so aggregate supply is reduced and shifts to the right This decreases the price further but brings the real output back to its level of full employment. Hence in total, price level falls multifold and output does not change
c) Higher nominal wages implies induce workers to work more and this increases the supply of labor. Production rises and AS shifts to the rigft. Real output rises and price level falls. In the short run price level falls and real output rises. Nominal wages are not changed but lower prices have increased real wages. This causes firms to demand less labor so again, AS falls and shifts to the left during long run transition. Hence in total, price level and output do not change
d) Highe efficiency implies more reduced cost of production so firms produce more. Production rises and AS shifts to the rigft. Real output rises and price level falls. In the short run price level falls and real output rises. Nominal wages are not changed but lower prices have increased real wages. This causes firms to demand less labor so again, AS falls and shifts to the left during long run transition. Hence in total, price level and output do not change
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