Review sections 7.2 and 7.3 of Chapter 7 in order to examine the relationship between the labor market dynamics and the achievement of equlibrium in the short run and the long run. Note the role of wage and price stickiness. Again suppose, with an aggregate demand curve at AD1 and a short-run aggregate supply at SRAS1, an economy is initially in equilibrium at its potential output YP, at a price level of P1, as shown in Figure 7.13 "Long-Run Adjustment to a Recessionary Gap". Now suppose that the short-run aggregate supply curve shifts owing to a rise in the cost of health
care. As we explained earlier, because health insurance premiums are paid primarily by firms for their workers, an increase in premiums raises the cost of production and causes a reduction in the short-run aggregate supply curve from SRAS1 to SRAS2. Figure 7.13 Long-Run Adjustment to a Recessionary Gap A decrease in aggregate supply from SRAS1 to SRAS2 reduces real GDP to Y2 and raises the price level to P2, creating a recessionary gap of YP − Y2. In the long run, as prices and nominal wages decrease, the short-run aggregate supply curve moves back to SRAS1 and real GDP returns to potential. As a result, the price level rises to P2 and real GDP falls to Y2. The economy now has a recessionary gap equal to the difference between YP and Y2. Notice that this situation is particularly disagreeable, because both unemployment and the price level rose. With real GDP below potential, though, there will eventually be pressure on the price level to fall. Increased unemployment also puts pressure on nominal wages to fall. In the long run, the short-run aggregate supply curve shifts back to SRAS1. In this case, real GDP returns to potential at YP, the price level falls back to P1, and employment returns to its natural level. These adjustments will close the recessionary gap. How sticky prices and nominal wages are will determine the time it takes for the economy to return to potential. People often expect the government or the central bank to respond in some way to try to close gaps. This issue is addressed next. I do not have all of the graphs in the answer key, but you need to be sure to always include graphs in your answers  1. a. The current state of the economy is shown in the figure above. The aggregate-demand curve and short-run aggregate-supply curve intersect at the same point on the long-run aggregate-supply curve. b. A stock market crash leads to a leftward shift of aggregate demand. The equilibrium level of output and the price level will fall. Because the quantity of output is less than the natural rate of output, the unemployment rate will rise above the natural rate of unemployment. c. If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time as expectations adjust, the short-run aggregate-supply curve will shift to the right, moving the economy back to the natural rate of output. 3. a. The current state of the economy is shown in the figure below. The aggregate-demand curve and short-run aggregate-supply curve intersect at the same point on the long-run aggregate-supply curve. b. If the central bank increases the money supply, aggregate demand shifts to the right (to point B). In the short run, there is an increase in output and the price level. c. Over time, nominal wages, prices, and perceptions will adjust to this new price level. As a result, the short-run aggregate-supply curve will shift to the left. The economy will return to its natural rate of output (point C). d. According to the sticky-wage theory, nominal wages at points A and B are equal. However, nominal wages at point C are higher. e. According to the sticky-wage theory, real wages at point B are lower than real wages at point A. However, real wages at points A and C are equal. f. Yes, this analysis is consistent with long-run monetary neutrality. In the long run, an increase in the money supply causes an increase in the nominal wage, but leaves the real wage unchanged. 9. a. People will likely expect that the new chairman will not actively fight inflation so they will expect the price level to rise. b. If people believe that the price level will be higher over the next year, workers will want higher nominal wages. c. Higher labor costs lead to reduced profitability. d. The short-run aggregate-supply curve will shift to the left as shown in Figure. e. A decline in short-run aggregate supply leads to reduced output and a higher price level. f. No, this choice was probably not wise. The end result is stagflation, which provides limited choices in terms of policies to remedy the situation. 10. a. If households decide to save a larger share of their income, they must spend less on consumer goods, so the aggregate-demand curve shifts to the left, as shown in Figure. The equilibrium changes from point A to point B, so the price level declines and output declines. b. If Florida orange groves suffer a prolonged period of below-freezing temperatures, the orange harvest will be reduced. This decline in output is represented by a shift to the left in the short-run aggregate-supply curve. the price level rises and output declines. c. If increased job opportunities cause people to leave the country, the long-run and shortrun aggregate-supply curves will shift to the left because there are fewer people producing output. The aggregate-demand curve will shift to the left because there are fewer people consuming goods and services. The result is a decline in the quantity of output, as Figure 14 shows. Whether the price level rises or declines depends on the relative sizes of the shifts in the aggregate-demand curve and the aggregate-supply curves. 10. a. When the stock market declines sharply, wealth declines, so the aggregate-demand curve shifts to the left, as shown in Figure 31-13. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A. Figure 31-13 Figure 31-14 b. When the federal government increases spending on national defense, the rise in government purchases shifts the aggregate-demand curve to the right, as shown in Figure 31-14. In the short run, the economy moves from point A to point B, as output and the price level rise. In the long run, the short-run aggregate-supply curve shifts to the left to restore equilibrium at point C, with unchanged output and a higher price level compared to point A. Figure 31-15 c. When a technological improvement raises productivity, the long-run and short-run aggregate-supply curves shift to the right, as shown in Figure 31-15. In the short run, the economy moves from point A to point B, as output rises and the price level declines. In the long run, the short-run aggregate-supply curve shifts further to the right to restore equilibrium at point C, with output higher and the price level lower compared to point A. Figure 31-16 d. When a recession overseas causes foreigners to buy fewer U.S. goods, net exports decline, so the aggregate-demand curve shifts to the left, as shown in Figure 31-16. In the short run, the economy moves from point A to point B, as output declines and the price level declines. In the long run, the short-run aggregate-supply curve shifts to the right to restore equilibrium at point C, with unchanged output and a lower price level compared to point A. What happens to nominal wages in the shortThe short-run aggregate supply curve is based on the assumption that firms and workers have established nominal wages, with the expectation that ______. What happens to nominal wages in the short run when the price level decreases? They remain unchanged.
How does price level affect nominal wages?When the price level rises, the nominal wage remains fixed because this is solely based on the dollar amount of the wage. The real wage, on the other hand, falls because this is based on the purchasing power of the wage. A higher price level means that a given wage is able to purchase fewer goods and services.
What happens to wages during a shortThe short run in macroeconomic analysis is a period in which wages and some other prices do not respond to changes in economic conditions. In certain markets, as economic conditions change, prices (including wages) may not adjust quickly enough to maintain equilibrium in these markets.
What happens to sras when nominal wages fall?Changes in nominal wages.
Likewise, the commodity prices and nominal wage increase the production cost, shifting the SRAS to the left. On the other hand, a decrease in nominal wage lowers production costs and shifts SRAS to the right.
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How will nominal wages respond to a decrease in the price level in the short run?
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