ch05 - CHAPTER 5 Solutions to the Problems in the Textbook...

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CHAPTER 5 Solutions to the Problems in the Textbook Conceptual Problems: 1. The aggregate supply curve shows the quantity of real total output that firms are willing to supply at each price level. The aggregate demand curve shows all combinations of real total output and the price level at which the goods and the money sectors are simultaneously in equilibrium. Along the AD-curve nominal money supply is assumed to be constant and no fiscal policy change takes place. 2. The classical aggregate supply curve is vertical, since the classical model assumes that nominal wages adjust very quickly to changes in the price level. This implies that the labor market is always in equilibrium and output is always at the full-employment level. If the AD-curve shifts to the right, firms try to increase output by hiring more workers, who they try to attract by offering higher nominal wages. But since we are already at full employment, no more workers can be hired and firms merely bid up nominal wages. The nominal wage increase is passed on in the form of higher product prices. In the end, the level of wages and prices will have increased proportionally, while the real wage rate and the levels of employment and output will remain unchanged. If there is a decrease in demand, then firms try to lay off workers. Workers, in turn, are willing to accept lower wages to stay employed. Lower wage costs enable firms to lower their product prices. In the end, nominal wages and prices will decrease proportionally but the real wage rate and the level of employment and output will remain the same. 3. There is no single theory of the aggregate supply curve, which shows the relationship between firms' output and the price level. A number of competing explanations exist for the fact that firms have a tendency to increase their output level as the price level increases. The Keynesian model of a horizontal aggregate supply curve supposedly describes the very short run (over a period of a few months or less), while the classical model of a vertical aggregate supply curve is supposed to hold true for the long run (a period of more than 10 years). The medium-run aggregate supply curve is most useful for periods of several quarters or a few years. This upward-sloping aggregate supply curve results from the fact that wage and price adjustments are slow and uncoordinated. Chapter 6 offers several explanations for the fact that labor markets do not adjust quickly. These include the imperfect information market-clearing model, the existence of wage contracts or coordination problems, and the fact that firms pay efficiency wages and price changes tend to be costly. 4. The Keynesian aggregate supply curve is horizontal since the price level is assumed to be fixed. It is most appropriate for the very short run (a period of a few months or less). The classical aggregate supply curve is vertical and output is assumed to be fixed at its potential level. It is most appropriate for the long run (a period of more than 10 years) when prices are able to fully adjust to all shocks. 5.
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This note was uploaded on 12/18/2010 for the course SOES 2003 taught by Professor Jian during the Fall '10 term at Uni. Southampton.

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ch05 - CHAPTER 5 Solutions to the Problems in the Textbook...

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