Chap036 - Chapter 36 Current Issues in Macro Theory and...

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Chapter 36 - Current Issues in Macro Theory and Policy Chapter 36 Current Issues in Macro Theory and Policy QUESTIONS 1. First, imagine that both input and output prices are fixed in the economy. What does the aggregate supply curve look like? If AD decreases in this situation, what will happen to equilibrium output and the price level? Next, imagine that input prices are fixed, but output prices are flexible. What does the aggregate supply curve look like? In this case, if AD decreases, what will happen to equilibrium output and the price level? Finally, if both input and output prices are fully flexible, what does the aggregate supply curve look like? In this case, if AD decreases, what will happen to equilibrium output and the price level? (To check your answers, review Figures 29.3, 29.4, and 29.5 in Chapter 29). LO1 Answer: In the immediate-short-run the aggregates supply schedule is horizontal. This is because all prices are fixed (input and output prices). If there is a decrease in aggregate demand this will cause output to fall and no change in the price level (input and output prices are fixed). In the short-run the aggregates supply schedule slopes upward. That is, as prices increase output increases as well. This is because input prices are fixed and output prices can adjust. If there is a decrease in aggregate demand this will cause output to fall and the price level will fall as well unless we assume that prices are rigid downward (the ratcheting effect, an assumption made in the previous chapters). In the long-run the aggregates supply schedule is vertical. This is because all prices are flexible (input and output prices). If there is a decrease in aggregate demand this will cause prices to fall and no change in output unless we assume that prices are rigid downward (the ratcheting effect, an assumption made in the previous chapters). 2. According to mainstream economists, what is the usual cause of macroeconomic instability? What role does the spending-income multiplier play in creating instability? How might adverse aggregate supply factors cause instability, according to mainstream economists? LO1 Answer: The mainstream view of macroeconomic instability is Keynesian-based and focuses on aggregate spending and its components. Particularly significant are changes in investment spending, which change aggregate demand and, occasionally, adverse supply shocks which change aggregate supply. Investment spending is subject to wide variations, and a “multiplier effect” magnifies these changes into even greater changes in aggregate demand, which can cause demand- pull inflation in the forward direction or a recession if investment spending falls. In the mainstream view, a second source of instability could arise on the supply side.
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