Vahe Avagyan April 18, 2012. Using a correctly labeled graph of aggregate supply and aggregate demand, show each of the following: i. Long-run aggregate.

Vahe AvagyanApril 18, 2012

a. Using a correctly labeled graph of aggregate supply and aggregate demand, show each of the following:i. Long-run aggregate supplyii. The output level, labeled YE, and

the price level, labeled PLE

i. Because the economy is in long run equilibrium, the long run aggregate supply curve is naturally vertical. As firms reach equilibrium, marginal costs decrease, and this, combined with a host of long-run factors, results in firms supplying at a constant, vertical level in the long run. (1 pt)

ii. Where the LRAS and SRAS curves meet with the Aggregate Demand Curve, we thus find the Equilibrium Price Level. The level of output is accordingly at the LRAS. (1 pt)

b. Assume consumer confidence falls. Show on your graph in part (a) the short-run impact of the change in consumer confidence and label the new equilibrium price level and output Y1 and PL1, respectively.

A negative change in consumer confidence, via the fourth economic law of common sense, dictates that Aggregate Demand will shift to the LEFT.

Thus, the new equilibrium price level is at PL1, where the new Aggregate Demand Curve meets the Short Run Aggregate Supply Curve (1 point)

c. Using a correctly labeled graph of the short-run and long-run Phillips curves, show the effect of the fall in consumer confidence on inflation. Label the initial long-run equilibrium point A and the new short-run equilibrium point B

The Short-Run Philips Curve must be downward sloping because of the inflation. (1 pt)

In the long run, however, the Philips Curve must be vertical. (1 pt) Because in the long run there is no trade off between unemployment and inflation, the Philips curve is vertical. This is the main contrast between SR and LR PC. Where they meet is point A (initial long-run equilibrium), but the new short-run equilibrium, point B, is further along the curve. (1 pt)

d. If the government and the central bank do not pursue any discretionary policy change, how does the fall in consumer confidence affect government transfer payments in Meekland? Explain.

A lack of discretionary policy change, dovetailed with falling consumer confidence, will result in more individuals applying for government benefits. This increase in number of individuals wanting government benefits will accordingly increase the number of transfer payments.

(1 point)

e. Draw a correctly labeled graph of the loanable funds market in Meekland and show the effect of the change in government transfer payments you identified in part (d) on the real interest rate

The graph of the loanable funds market shows two curves, supply and demand, with the vertical axis labeled real interest rate and the horizontal axis labeled quantity of funds. (1 point)

The Increase in Transfer Payments that we noted in d results in a leftward shift of the supply curve. As a result, the real interest rate INCREASES. (1 point)

f. In the absence of any changes in fiscal and monetary policies, in the long run will the short-run aggregate supply curve shift to the left, shift to the right, or remain unchanged as a result of the fall in consumer confidence? Explain.

The fall in consumer confidence, along with no changes made to fiscal and monetary policy, will cause wages and input costs to fall. As a result, the SRAS curve will shift to the RIGHT.

One point