Chapter 26 Answers to Short-Answer, Essays, and Problems

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1 Chapter 26 Answers to Short-Answer, Essays, and Problems 1. Why is there a need for an aggregate demand and aggregate supply model of the economy? Why can t the supply and demand model for a single product explain developments in the economy? The basic reason for an aggregate model is that there are thousands of individual products in an economy. Single product supply and demand model does not explain: (1) why prices in general rise or fall; (2) what determines the level of aggregate output; and (3) what determines changes in the level of aggregate output. The aggregate model is needed to explain these changes. It simplifies the analysis of prices by combining the prices of all individual goods and services into one aggregate price level. It simplifies the analysis of quantities by combining the equilibrium quantities of all individual goods and services into a singe entity called the real domestic output. 2. What is the aggregate demand curve? What is the character of its slope? The aggregate demand curve shows the relationship between the price level and real domestic output (real GDP). It shows the amounts of real output that domestic consumers, businesses, government, and foreign buyers collectively desire to purchase at each price level. As the price level increases, the amount of real domestic output purchased will decrease, so the aggregate demand curve is downsloping. 3. What is the difference in the explanation of the shape of the aggregate demand curve and a single product demand curve? After all, both demand curves show an inverse relationship between price and quantity. The aggregate demand curve shows an inverse relationship between the price level (the general level of all prices) and real domestic output (the equilibrium quantity of all products). The explanation of this inverse relationship is based on the real-balances effect, the interest-rate effect, and the foreign-purchases effect. In this case, as the price level rises, the quantity of real domestic output decreases. The supply and demand model for a particular product shows an inverse relationship between the price of that product and the quantity of that product. The explanation for the inverse relationship between price and quantity in the demand for a single product is based on the substitution and income effects. The substitution effect is not applicable to the aggregate case because there is no substitute for all products in the economy. Also, the income effect is not applicable to the aggregate case because income now varies with aggregate output. 4. Why can t the substitution and income effects be used to explain the downward slope of the aggregate demand curve? In terms of the substitution effect, with a single product, a lower price makes the good relatively less expensive compared to other goods. With aggregate demand, a lower aggregate price level lowers the price of all goods and doesn t make one relatively less expensive compared to another, so the substitution effect isn t applicable. For the income effect, for a single product, a decrease in price raises the consumer s real income allowing the purchase of more goods. In the case of aggregate demand, a lower price level means less income for producers and suppliers of goods and although goods are less expensive for consumers, the combined effect doesn t translate necessarily to a higher total income level, so the income effect doesn t apply. 5. Explain the three reasons given for the downward slope of the aggregate demand curve. The three reasons given are the real-balances effect, the interest-rate effect, and the foreign purchases effect. The real-balances effect refers to the idea that a higher price level will reduce the purchasing power of the population s accumulated financial assets. Because of the decline in value of such assets, people will feel poorer and will reduce their spending. Conversely, as the price level falls the opposite will occur.

2 The interest-rate effect assumes that as the price level rises so will interest rates, and rising interest rates will reduce certain kinds of spending such as consumption spending on durable goods and investment spending. The foreign purchases effect assumes that if the price level rises in the U.S. relative to that in foreign countries, Americans will increase spending on imports at the expense of domestically produced goods and services, and foreigners will reduce purchases of U.S. goods. In other words, net exports decline. 6. The determinants of aggregate demand determine the location of the aggregate demand curve. What are the four basic determinants of aggregate demand. The four basic determinants of aggregate demand are: (a) a change in consumer spending; (b) a change in investment spending; (c) a change in government spending; and, (d) a change in net export spending 7. Identify three factors that affect consumer spending. How does a change in consumer spending affect aggregate demand? A change in consumer spending could occur as a result of an increase or decrease in consumer wealth resulting from factors such as increased stock values. It also could be caused by a change in consumer expectations about the future, a change in the level of household borrowing, or a change in personal taxes. If consumer spending increases, aggregate demand is likely to increase. If consumer spending decreases, aggregate demand is likely to decrease. 8. Identify two basic factors that affect investment spending. How does a change in investment spending affect aggregate demand? Changes in investment spending may occur as a result of changes in the interest rate (not related to changes in the price level), changes in profit expectations having to do with predictions about future returns on possible projects, changes in business taxes, technological improvements which induce more capital investment, and the degree of existing excess capacity. If investment spending increases, aggregate demand is likely to increase. If investment spending decreases, aggregate demand is likely to decrease. 9. How does a change in investment spending affect aggregate demand? Government spending might change for any of a number of reasons, including a change in priorities resulting from a change in decisions by elected government officials. If government spending increases, aggregate demand is likely to increase. If government spending decreases, aggregate demand is likely to decrease. 10. State two basic factors that affect net export spending. How does a change in net export spending affect aggregate demand? Net export spending can change for two nonprice-level-related reasons such as rising or falling national incomes in other countries and exchange rate changes unrelated to changes in domestic price levels. If net export spending increases, aggregate demand is likely to increase. If net export spending decreases, aggregate demand is likely to decrease.

3 11. Identify the ways in which each of the following determinants would have to change if each was causing a decrease in aggregate demand: consumer wealth, consumer expectations, business taxes, national income in countries abroad, exchange rates. To decrease aggregate demand, consumer wealth would have to fall. For example, a decline in real estate values or a stock market decline would cause a decrease in consumer wealth. If consumers expected prices to fall in the future, or a recession which creates insecurity about jobs, they might cut back on spending now. If business taxes were raised, or some present tax breaks eliminated or reduced, this could reduce business investment spending which, in turn, reduces aggregate demand. When national income abroad is falling, U.S. exports will decline, which reduces the net export spending component of aggregate demand. A dollar appreciation will cause a decline in net exports as U.S. exports become more expensive to foreigners and foreign imports become less expensive to holders of American dollars. 12. Describe the likely effect of the following events would on the aggregate demand (AD) curve. (a) A boost in research and development by computer companies produces more powerful and efficient computers and equipment. (b) Income falls in several countries that trade heavily with the U.S. (c) Prices fall across several industries. (d) After a budget surplus, Congress moves to cut personal income taxes. (a) This would cause a shift outward of the AD curve. Better technology increases the expected returns on investment, causing investment to increase and the AD curve to shift outward. (b) This could cause the AD curve to shift inward. Lower incomes abroad mean less foreign demand for U.S. goods, so AD shifts inward at all price levels. (c) This will not cause a shift in the AD curve, since prices are not a component of AD. Rather, a fall in prices will cause a movement downward and outward along the AD curve. (d) This will shift the AD curve outward. Lower taxes mean that households have more to spend, so AD will increase at all price levels. 13. What are the three time horizons used to categorize aggregate supply? What is the difference between the immediate short-run and the short-run aggregate supply? The three time horizons used to categorize the aggregate supply curve are the immediate short run, the short run and the long run. In the immediate short run, both input and output prices are fixed, and the aggregate supply curve is horizontal. The aggregate supply curve in the short run is upsloping because the price of output could vary. The price of inputs, however, is also fixed in the short run. The main difference between the immediate short-run and the short-run aggregate supply is then the flexibility of output prices in the short run. 14. Define aggregate supply. Describe the characteristics of the aggregate supply curve in the immediate shortrun, short-run and long-run perspectives. The aggregate supply curve is one that shows the total quantity of goods and services that will be produced (supplied) at different price levels. In the immediate short run, the aggregate supply curve is horizontal because nominal wages, input prices and output prices are fixed and firms collectively supply exactly the level of output demanded at any given price level. In the short run, the aggregate supply curve is upsloping because nominal wages and input prices adjust only slowly to changes in the price level. With this curve, an increase in the price level increases real output and a decrease in the price level reduces real output. In the long run, the aggregate supply curve is vertical at the full-employment level of output for the economy because the rise in wages and other inputs will match changes in the price level.

4 15. Explain the rationale for the shape of the short-run aggregate supply curve in the immediate short run. In the immediate short run, the aggregate supply curve is horizontal at a particular price level. In the immediate short run, input prices for firms are fixed because of labor and other resource contracts that fix the price of inputs. Also, output prices are fixed because of supplier contracts with buyers to supply as much of the product that a buyer wants. The horizontal shape means that the total amount of output supplied depends on the volume of spending that results in a particular price level. 16. Explain the reasoning behind the shape of the short-run aggregate supply curve in the short run. The curve is relatively flat at low levels of price and output because at that level, resources for production, such as machinery and people, are abundantly available and few shortages occur. Thus the per-unit cost of production does not rise that much as output increases. Past full-employment, resources become scarce and there are diminishing returns to additional capital and labor. As scarcity and bottlenecks occur at higher levels of production, the per-unit cost of production increases, causing the slope of the aggregate supply curve to steepen. 17. What factors determine the vertical shape of the aggregate supply curve in the long-run? Explain. The long-run aggregate supply curve is vertical at the economy s full-employment level of output. The shape of this curve is determined by flexible input and output prices that allow firms to adjust their profits so as to always have an incentive to produce at the full-employment level of output. In the long run, an increase in output prices will generate an increase in wages and input prices. 18. Identify the three major factors that can cause a shift in aggregate supply. The determinants of supply include: (a) changes in input prices; (b) changes in productivity; and, (c) changes in the legal-institutional environment. 19. What are two underlying factors affecting input prices? How does a change in input prices affect aggregate supply? Included as factors behind changes in input prices are the prices of domestic resources and the prices of imported resources. If domestic prices fall or the prices of imported resources fall, then input prices will fall. A decline in input prices will likely increase aggregate supply. If domestic prices rise or the prices of imported resources rise, then input prices will rise. An increase in input prices will likely decrease aggregate supply. 20. How will a change in productivity increase or decrease aggregate supply? If productivity increases, this change will lead to a decrease in per-unit production costs. The decline in per-unit production costs increases aggregate supply. If productivity decreases, this change will lead to an increase in per-unit production costs. The increase in per-unit production costs decreases aggregate supply. 21. What two factors affect the legal-institutional environment? Discuss the effect of changes in the legalinstitutional environment on aggregate supply. Included as factors related to the legal-institutional environment are business taxes and business subsidies, and government regulation. If business taxes increase, business subsidies decrease, or government regulations increase, these changes increase the cost of doing business. As a consequence, aggregate supply will likely decrease. If business taxes decrease, business subsidies increase, or government regulations decrease, these changes decrease the cost of doing business. As a consequence, aggregate supply will likely increase.

5 22. Describe the change in aggregate supply that should result from each of the following changes in determinants. Assume that nothing else is changing besides the identified change. (Use Decrease or Increase. ) (a) A rise in the average price of inputs; (b) An increase in worker productivity; (c) Government antipollution regulations become stricter; (d) A new subsidy program is enacted for new business investment in productive equipment; (e) Energy prices decline. (a) Decrease; (b) Increase; (c) Decrease (unless the increase in antipollution device production outweighs the decline in production caused by the increased cost of the regulations); (d) Increase; (e) Increase 23. Prepare a list of events that would shift the aggregate supply curve leftward. Students should list examples that fit the determinants indicated in Figure Some possibilities are a rise in the prices of domestic resources, an increase in wages beyond any rise in productivity, an increase in the prices of imported resources, declining rate of productivity without corresponding wage concessions, rising business taxes, reduction in research and development efforts, and more government regulation which adds to production costs. 24. Prepare a list of government tax or spending policy options that would tend to shift the aggregate supply curve rightward. Tax cuts or rebates in any area which would improve productivity. For example, tax credits for investment in new capital goods or buildings, tax credits for education and training. Tax breaks for various types of natural resource exploration and development especially for resources important in energy and construction industries. Reducing or eliminating tariffs on imported resources. Tax penalties for companies which grant inflationary wage increases. [text: E pp ; MA pp ] 25. What determines the equilibrium price level and the level of real domestic output in the aggregate demand aggregate supply model? The interaction of aggregate supply and aggregate demand will determine the equilibrium. The price and quantity levels where aggregate demand and aggregate supply are equal will be the equilibrium levels of price and quantity. In a graphical illustration such as Figure 29.7, it is where the two curves intersect. 26. What happens to bring the AD AS system back into equilibrium when prices are below the equilibrium level? Above the equilibrium level? When prices are below the equilibrium level, there is excess demand for goods. This will cause prices to rise, thanks to demand-pull inflation, as businesses raise prices to deal with the high demand. Prices will then rise and stabilize at their equilibrium level. When prices are above the equilibrium level there will be an excess supply of goods at that price level. Without enough people to purchase goods at their current prices, producers will lower prices to provoke demand. Producers will continue to lower prices until production matches demand and the equilibrium price level is reached.

6 27. Suppose that a hypothetical economy has the following relationship between its real domestic output and the input quantities necessary for producing that level of output. Input quantity Real domestic output (a) What is the level of productivity in this economy? (b) What is the unit cost of production if the price of each input is $2.00? (c) If the input price decreases from $2 to $1.50, what is the new per unit cost of production? In what direction would the aggregate supply curve move? What effect would this shift have on the price level and the level of real domestic output if the economy is initially operating in the intermediate range? (d) Suppose that instead of the input price decreasing, the productivity had increased by 25 percent. What will be the new unit cost of production? In what direction would the aggregate supply curve move? What effect would this shift have on the equilibrium price and output level if the economy? (a) The level of productivity is 2 output units per input unit. (b) Since productivity is 2 units of output per input unit, the cost of production per unit is 2 units /$2 or $1 per unit of output. (Total input cost/output) = PUPC. [($2 400)/800] = $1. (c) The unit cost will decline from $1/unit to $.75/unit. The aggregate supply curve has moved rightward and the level of prices has declined while the level of real domestic output has increased. (d) If productivity rose by 25 percent, then there would be 1.25 units produced per $1 of input costs. The unit cost of production would be $.80/unit. The aggregate supply curve would move in the same direction with similar effects to (c) above. However, the cost reduction is not quite as great so the real GDP would not rise as much as (c) nor would the price level decline by as much as (c). 28. Suppose the aggregate demand and supply schedules for a hypothetical economy are as shown below. Amount of real domestic output demanded, billions Price level (price index) Amount of real domestic output supplied, billions $ $ (a) Use these sets of data to graph the aggregate demand and supply curves on the below graph. (b) What will be the equilibrium price and output level in this hypothetical economy? Is it also the fullemployment level of output? Explain. (c) Why won t the 150 index be the equilibrium price level? Why won t the 250 index be the equilibrium price level? (d) Suppose demand increases by $400 billion at each price level. What will be the new equilibrium price and output levels? (e) What factors might cause a change in aggregate demand?

7 (a) See graph. (b) The equilibrium GDP is $600 billion and price level 200. There is not enough information given to determine whether or not this is the full-employment level of output. (c) At 150, the aggregate demand would exceed aggregate supply and prices would be bid up. At price level 250, aggregate supply would exceed aggregate demand and the resulting surpluses would cause prices to be bid downward toward the equilibrium level of 200. (d) The new equilibrium price and output level will be 250 and $800 billion respectively on the schedule shown. (e) An increase in consumer wealth, expected future inflation, decline in household borrowing, or decreased personal taxes could increase the consumer spending component of aggregate demand. Investment spending might increase as a result of lower interest rates, expectations of improved profits in the future, decline in business taxes, new and improved technology, or decline in excess capacity. Government spending might increase for a variety of reasons. Net export spending could increase as a result of improved economic conditions abroad or a depreciation in the U.S. dollar. 29. Suppose the aggregate demand and supply schedules for a hypothetical economy are as shown below. Amount of real domestic output demanded, billions Price level (price index) Amount of real domestic output supplied, billions $ $ (a) What will be the equilibrium price and output level in this hypothetical economy? Is it also the fullemployment level of output? Explain. (b) Why won t the 200 index be the equilibrium price level? Why won t the 300 index be the equilibrium price level? (c) Suppose demand increases by $120 billion at each price level. What will be the new equilibrium price and output levels? (d) List five factors that might cause a change in aggregate demand. (a) The equilibrium GDP is $180 billion and price level 250. There is not enough information given to determine whether or not this is the full-employment level of output, but there is no reason why it should be one way or the other. (b) At 200, the aggregate demand would exceed aggregate supply and prices would be bid up. At price level 300, aggregate supply would exceed aggregate demand and the resulting surpluses would cause prices to be bid downward toward the equilibrium level of 250. (c) The new equilibrium price and output level will be 300 and $240 billion respectively on the schedule shown.

8 (d) (1) An increase in consumer wealth, (2) expected future inflation, (3) decline in household borrowing, or (4) decreased personal taxes could increase the consumer spending component of aggregate demand, (5) investment spending might increase as a result of lower interest rates, (6) expectations of improved profits in the future, (7) decline in business taxes, (8) new and improved technology, or (9) decline in excess capacity. Government spending might increase for a variety of reasons. (10) Net export spending could increase as a result of improved economic conditions abroad or from a depreciation in the U.S. dollar. 30. Describe each of the following outcomes in terms of shifts in aggregate demand or aggregate supply curves. (a) A recession deepens while the rate of inflation increases (b) The price level rises sharply while real output and employment increase (c) The price level falls, but the unemployment rate rises (d) Real output rises, unemployment rate falls, and the price level rises (a) The aggregate supply curve has shifted to the left causing the price level to rise and output and employment levels to fall. (b) The aggregate demand curve has shifted to the right. (c) The aggregate demand curve has shifted leftward. (d) The aggregate demand curve has shifted rightward. 31. Evaluate the effect of the following on the AD curve, AS curve, equilibrium price level and equilibrium output. (a) The U.S. imposes tariffs on foreign goods to promote domestic industry. In retaliation, foreign countries impose tariffs on U.S. goods. (b) Congress decides to decrease personal income taxes, and to compensate for the lost revenue they decrease business subsidies. (c) A technology boom improves technology across industries, improving their productivity. (d) U.S. oil companies discover new large oil reserves in the U.S. The international price of oil falls. (a) The tariffs imposed on foreign goods increase the price of foreign resources for domestic producers, causing the aggregate supply curve to shift inward. The tariffs on U.S. goods decrease foreign demand for U.S. goods, decreasing net exports and causing the aggregate demand curve to shift inward. These shifts cause output to decrease and have an uncertain effect on the price level. (b) The decrease in personal income taxes causes a shift outward of the AD curve. The decrease in business subsidies increases the per-unit cost of production and thus shifts the AS curve in. This causes the price level to rise and has an uncertain effect on output. (c) The improvement in technology improves expected rates of return, increasing investment spending and shifting the AD curve outward. The improved technology also increases productivity, which shifts the AS curve outward. This increases equilibrium output and has an uncertain effect on the price level. (d) The discovery of oil both increases U.S. oil companies market share and decreases the input cost of oil for U.S. companies in general. This results in a large shift outward of the AS curve. The total effect is an increase in equilibrium output and a decrease in the equilibrium price level. 32. What is the effect of the multiplier when aggregate demand increases and there is a large increase in the price level? What happens when there only is a small increase in the price level? The multiplier effect is weakened with price level changes. In the vertical range of aggregate supply, an increase in aggregate demand only produces in increase in the price level but no increase in real output. In the intermediate range, the increase in aggregate demand raises the price level and real output, but real output does not increase by as much as it would have if there had been no price level increase (as would be the case in the horizontal range). The conclusion is that the more the price level increases, the less effect any increase in aggregate demand will have in increasing real GDP. 33. In the table below are aggregate demand and supply schedules.

9 Price level Real domestic output Demanded Supplied (1) (2) (3) (4) (a) On the graph below, plot the aggregate demand curve shown in columns (1) and (2) in the above table, and label this curve AD 1. (b) On the graph below, plot the aggregate supply curve shown in columns (1) and (4) in the above table; and label this curve AS. (c) What is the level of equilibrium real domestic output and price level? (d) Now assume that aggregate demand changes. Use columns (1) and (3) to plot the new aggregate demand curve; and label this curve AD 2. (e) What is the new level of equilibrium real domestic output and price level? (a) See graph. (b) See graph. (c) 1700; 175. (d) See graph. (e) 2000; Use this aggregate demand aggregate supply schedule for a hypothetical economy to answer the following questions. Real domestic output demanded (in billions) Price level Real domestic output supplied (in billions) $ $ (a) What will be the equilibrium price level and quantity of real domestic output? (b) If the quantity of real domestic output demanded increased by $2000 at each price level, what will be the new equilibrium price level and quantity of real domestic output? (c) Using the original data from the table, if the quantity of real domestic output demanded increased by $5000 and the quantity of real domestic output supplied increased by $1000 at each price level, what would the new equilibrium price level and quantity of real domestic output be? (a) 200 and $6000. (b) 250 and $7000. (c) 300 and $9000.

10 35. What are five reasons for the downward price-level inflexibility, especially as it pertains to wages and prices? First, there is the fear of a price war. If one business starts cutting prices then other businesses can follow suit to maintain market share. Businesses may decide to maintain prices rather than risk starting a price war. Second, there are menu costs of changing prices. Repricing or reprinting prices can be costly and be disruptive to customers. Businesses are reluctant to make such changes. Third, wage contracts will fix wages for the length of the contract period, so it is difficult to cut wages until the contract is renegotiated. Also, wages and salaries of nonunion workers are typically adjusted just once a year. Fourth, some businesses may pay efficiency wages that are designed to get the maximum work effort out of employees. Cutting such wages may cause morale problems and reduce productivity, so businesses are hesitant to make these cuts. Fifth, the minimum wage sets a legal minimum that employers must pay for low-skilled workers. 36. Is there downward price inflexibility applicable to today s economy? What factors might explain it? Economists give many reasons for the downward price-level inflexibility in the economy. They note that the price level has not declined since one year in the 1950s despite the fact that there have been many recessions since then, including the severe recession of The reasons for price-level inflexibility include fear of price wars, the menu cost of making price changes, long-term wage contracts, the payment of efficiency wages, and a minimum wage. 37. (Consider This) What is the ratchet effect? How does it apply to price level changes in the economy as aggregate demand changes? A ratchet effect allows movement in one direction but not movement back. Some economists argue that when aggregate demand increases, there will be an increase in the price level, but when aggregate demand decreases, there is downward price inflexibility that prevents the price level from falling. They note that the price level has not declined since one year in the 1950s despite the fact that there have been many recessions since then. So a higher price level remains even when aggregate demand falls. 38. Explain cost-push inflation using aggregate demand aggregate supply analysis. Cost-push inflation using the AD AS analysis could be explained by a leftward shift in the aggregate supply curve. If aggregate supply decreases in this manner, it will intersect the aggregate demand curve at a lower real GDP and a higher price level since the aggregate demand curve is downsloping. This view suggests that prices might rise even if aggregate demand has not increased. The more traditional view has been that inflation is caused by increases in aggregate demand at or near the full-employment level of GDP. 39. Some economists argue that it is easier to resolve demand-pull inflation than it is cost-push inflation. Use the aggregate demand and aggregate supply model to explain this assertion. By shifting aggregate demand leftward when the equilibrium occurs in the intermediate or classical range, the inflation rate should fall. This assumes that the price-level increase was due to demand factors only. It is possible to decrease aggregate demand by using tax policies which decrease consumer or business spending, or by using monetary policies which tighten the availability of credit for spending. However, the factors which cause leftward shifts in the aggregate supply schedule (see Figure 29.6) are not as easy for government policy to control. Government cannot quickly change worker demands for higher wages; it cannot quickly increase productivity which would also bring down production costs; it cannot control the price of imported resources. These three factors have contributed much to cost-push inflation in the past, and help to illustrate the difficulty in controlling cost-push inflation. 40. How would the following developments affect aggregate demand or aggregate supply? (a) A reduction in personal income taxes.

11 (b) More funding for research and development in new technologies. (c) An increase in business subsidies. (a) A reduction of personal taxes causes an increase in consumption which shifts the AD curve outward. This causes an increase in both output and the price level. For this reason, a is not a good fiscal policy option. (b) An increase in funding of research and development in new technology first increases the expected returns on investment, thereby increasing the level of investment and shifting out the AD curve. The shift results in an increase in equilibrium GDP and in the price level, depending on how the shifts in AD and AS balance out. (c) An increase in business subsidies reduces the per-unit cost of production for businesses and thus causes an outward shift of the AS curve. This shift causes output to increase and lowers the price level. 41. Suppose an economic advisor to the President recommended a personal income tax increase. Indicate the expected effects on aggregate demand and on aggregate supply. The advisor would recommend this in hopes of dampening consumer demand and lessening demand-pull inflation. This should happen as consumers find themselves with less disposable income. However, at the same time there may be some less desirable effects on aggregate supply. For example, workers might demand higher wages to compensate for the higher taxes. Higher taxes may cause lessened work incentives which could cause a decline in productivity and, therefore, a rise in production costs. In other words, while raising personal taxes seems to be a correct policy for dampening demand and demand-pull inflation, it may have an offsetting effect on supply which could cause cost-push inflation. 42. Use an aggregate demand aggregate supply analysis to explain the impact of the public s expectations of severe inflation on real domestic output and the price level. The answer depends partly on where the economy is at the beginning of this change. Assuming that inflation was already a problem, then increased expectations would cause the demand curve to shift further rightward, adding to the demand-pull type of inflation. The effect on aggregate supply would also be to worsen inflation from the cost-push perspective. People would want higher wages and salaries now to compensate them for the expected inflation of the future. Unless productivity rose at the same rate, these demands for higher incomes would push up labor costs of production which would shift the supply curve to the left. As this happens the new equilibrium would be not only at a higher level of inflation, but also at a lower level of employment. In other words, this leftward shift could offset any possible increase caused by the rightward shift in aggregate demand. The only certainty is that expectations of severe inflation add to the probability of severe inflation because of the behavior of consumers and wage earners.

12 43. How can an economy achieve full employment without igniting inflation? An increase in aggregate demand will help an economy achieve full employment, but it also has the effect of increasing the price level and contributing to inflation. That inflation effect can be mitigated by an increase in aggregate supply that tends to dampen the rising inflation. The U.S. economy experienced such conditions from 1996 to (Last Word) Have rises in oil prices lost their inflationary punch in the United States? If so, why? Yes, economists estimate that the U.S. economy is 33 percent less sensitive to changes in oil prices than in the 1980s and 50 percent less sensitive than in the mid-1970s. The United States has become less sensitive for a number of reasons. First, lower production costs have more than compensated for the rise in energy prices. Second, oil has become less important in production than in the past, as the makeup of the U.S. economy shifted to less oil-intensive products. Lastly, the Federal Reserve has actively monitored the effect of oil on the price level and used monetary policy tools to maintain price stability. 45. (Last Word) Based on the discussion in the text, use the AD AS framework to depict why the rise in oil prices has had less effect on prices than in the past. A rise in oil prices raises the per-unit production cost for businesses, which causes the AS curve to shift inward. This shift reduces output and raises the price level. But, a reduction in production costs has more than compensated for the effect of an increase in oil prices. This increase in productivity is reflected in an outward shift of the AS curve. This results in an increase in output slightly beyond the original level before the increase in oil prices and a price level slightly below the original price level. If the change in production costs is from an improvement in technology, this will also increase expected rates of return on investment, increasing investment and shifting the AD curve outward. This would result in a greater increase in output and an uncertain effect on prices, depending on the extent of the shift. 46. (Last Word) Has the effect of oil prices increases on the economy been diminished? Cite evidence to support the case for a diminished effect. An increase in oil prices has been thought to contribute to stagflation. Oil prices are a major input into the cost of producing many products. If this price increases, then the AS curve would decrease, driving up the price level and reducing real output. Several reasons are cited as to why the oil price increase in the late 1990s has been less severe than would be expected. First, some firms that used oil-related products for production may have thought that any oil price increases would be temporary, and thus did not change their production plans or prices. Second, and perhaps most important, other factors affecting aggregate supply may have offset the negative effects of the oil price increase. One such factor would be an increase in productivity due to investments in new technology. Third, the nation is less sensitive to changes in oil prices than in past decades because it uses less energy to produce GDP. The Federal Reserve has also become more adept using monetary policy to respond to short-term changes in energy prices so that they have less of an effect on the core inflation rate.