EXERCISES ON THE AGGREGATE SUPPLY AGGREGATE DEMAND MODEL

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1 EXERCISES ON THE AGGREGATE SULY AGGREGATE DEMAND MODEL Question 1 Basic concepts 1. Explain briefly: a) Why the aggregate demand curve shifts to the right when there is an increase in the exchange rate (E)? b) Why the aggregate supply curve shifts upward when payroll taxes are increased? 2. Here are two economic scenarios : Scenario 1 The real interest rate goes down The price of raw materials goes up Scenario 2 The real interest rate goes up The price of raw material goes down Assuming that the economy is initially in a static equilibrium (there are no upward trends in either AS or AD), which scenario can explain the following prediction? Real GD will remain stable next year but the aggregate price level will fall. Answer with the appropriate graph. Question 2 A look at the American economy In the second half of the 1990 s, year after year, most analysts were predicting that inflation would accelerate in the US. Their prediction was based on the low rate of unemployment which was below 5 %. Despite the prediction, inflation remained remarkably stable at a rate of about 3 % per year. a) Explain the reasoning of the analysts who thought the inflation rate would increase (6-8 lines at most + graph) b) Aggregate demand increased very rapidly in the US after the recession of the 1990 s. However, according to Business Week (October 9, 1995), the US experienced at the same time an atypical productivity boom.

2 i. Could this explain why inflation remained stable in the US during the 1990 s? Refer to the aggregate demand aggregate supply model. ii. Other analysts are questioning the existence of a fixed natural rate of unemployment in the US. Could this be another part of the explanation for the stability of the rate of inflation?

3 SOLUTIONS Question 1 1 a) When E increases, foreign goods and services become more expensive relative to domestic goods and services. This tends to increase exports and decrease imports. Net exports improve and so does aggregate demand since AD = DA + (X-M). b) An increase in payroll taxes does the same to labor units costs as an increase in wage rates. Whatever its source, an increase in unit labor costs shifts the aggregate supply curve upward. 2 As can be seen in the graphs below, only the second scenario is compatible with the prediction. An increase in the real interest rate discourages consumption and investment and thus induces a leftward shift in the aggregate demand curve. With a decrease in the price of raw materials, the aggregate supply curve shifts downward which allows GD to stay constant while accentuating the downward pressures on prices. Scenario Y 0 = Y 1 The first scenario 1 (see next page) implies a rightward shift in the aggregate demand curve (a lower r stimulates C and I) and an upward shift in the aggregate supply curve (the impact of a rise in the price of raw materials). Although these two shifts tend to offset each other as far as GD is concerned, they both contribute to a rise in the aggregate price level.

4 Scenario Y 0 = Y 1 Question 2 a) Their reasoning was the following. With such a low rate of unemployment, the American economy was very close to its «natural» rate implying that the equilibrium between aggregate demand and aggregate supply was already in the rising cost section of the supply curve. In these circumstances, a rapid increase in aggregate demand would put upward pressures on unit costs and prices. Given the very low rate of unemployment, workers could reasonably ask for wage increases to be compensated for the increase in the cost of living. As aggregate demand would keep shifting to the right, the aggregate supply would be shifting upward. The inflation rate would accelerate (prices increasing from 0 to 1, then 2 and so forth). AS AD 2 Y 0 = Y 1 = Y 2

5 b) i) roductivity gains imply a rightward and downward shift in the aggregate supply curve. In these conditions, prices could be stable even if demand increased rapidly (they could even fall under certain conditions). Workers would not have to ask for higher wages just to be compensated for an increase in the cost of living. The upward shifts in the aggregate supply curve would stay modest and the rate of inflation could remain stable. ii) The natural rate of unemployment could be lower than we thought and so the macroeconomic equilibrium would still be in the flat part of the aggregate supply curve. There is still room for aggregate demand to rise without putting upward pressures on unit costs. The following graph combines both explanations AS AS AD AD

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