9.3 Aggregate Demand and Supply Shocks

Question 1

What does a positive aggrigate demand shock look like on a graph?

Answer 1

Question 2

What are the effects of a positive AD shock?

Answer 2

A positive AD shock first raises prices and output along the AS curve. It then induces a shift of the AS curve that further raises prices but lowers output along the new AD curve.

Question 3

What does the inflationary gap from a positive AD shock result in?

Answer 3

The inflationary gap results in an increase in wages and other factor prices, which drives up firms’ unit costs and shifts the AS curve upward.

As this happens, output falls and the price level rises along AD1 .

Eventually, when the AS curve has shifted to AS1, output is back to Y(*) and the inflationary gap has been eliminated. However, the price level has risen to P2 .

The eventual effect of the AD shock, after all adjustment has occurred, is to raise the price level but leave real GDP unchanged.

Question 4

History of the Philips curve

Answer 4

In his early models, he related the
rate of inflation to the difference between actual and potential output.

Later he investigated the empirical underpinnings of this equation by studying the relationship between the rate of change of nominal wages and the level of unemployment.

This relationship came to be known as the Phillips curve, which provided an explanation, rooted in empirical observation, of the speed with which wage changes shifted the AS curve by changing firms’ unit costs.

Question 5

What relationship is focused on in the Philips curve that became famous?

Answer 5

In the form in which it became famous, the Phillips curve related wage changes to the level of unemployment.

Question 6

Explain in simple terms how Inflationary and ressesionary gaps effect wages.

Answer 6

Question 7

What is the difference between the Phillips curve and the AS curve?

Answer 7

Note that the Phillips curve is not the same as the AS curve. The AS curve has the price level on the vertical axis whereas the Phillips curve has the rate of change of nominal wages on the vertical axis. How are the two curves related?
The economy’s location on the Phillips curve indicates how the AS curve is shifting as a result of the existing output gap.

Question 8

What assumtions are we making about an inflationary output gap?

Answer 8

We have assumed that an inflationary output gap leads to increases in factor prices, which cause firms’ unit costs to rise. The AS curve begins to shift up as firms respond by increasing their output prices. As seen in part (ii) of the figure, the upward shift of the AS curve causes a further rise in the price level, but this time the price rise is associated with a fall in output

Question 9

How long does an increase in unit costs resulting from a positive AD shock occure?

Answer 9

The increases in unit costs (and the consequent upward shifts of the AS curve) continue until the inflationary gap has been removed—that is, until in part (ii) real GDP returns to Y* .

Only then is there no excess demand for labour and other factors, and only then do factor prices and unit costs, and hence the AS curve, stabilize.

Question 10

What effect does the adjustment in wages and other factor prices (resulting from a positive AD shock) have

Answer 10

The adjustment in wages and other factor prices eventually eliminates any inflationary output gap caused by an AD shock; real GDP returns to its potential level.

Question 11

What does a negative AD shock look like graphically?

Answer 11

Question 12

What is the first effect of a negative AD shock?

Answer 12

A negative AD shock first lowers the price level and GDP along the AS curve and then induces a (possibly slow) shift of the AS curve that further lowers prices but raises output along the new AD curve.

Question 13

What does the fall in wages and other factor prices (Resulting from a negative AD shock) do to the AS curve

Answer 13

The fall in wages and other factor prices shifts the AS curve downward. Real GDP rises, and the price level falls further along the new AD curve. Unless factor prices are completely rigid, the AS curve eventually reaches AS1 , with equilibrium at E2. The eventual effect of the negative AD shock, after all adjustment has occurred, is to reduce the price level but leave real GDP unchanged.

Question 14

What are the first effects of a negative AD shock?

Answer 14

The first effects of the decline are a fall in output and some downward adjustment of prices, as shown in part (i) of the figure. As real GDP falls below potential, a recessionary gap is created, and unemployment rises. At this point we must analyze two separate cases.

The first occurs when wages and other factor prices fall quickly in response to the excess supply of factors.

The second occurs when factor prices fall only slowly.

Question 15

What happens when wages fall rapidly in the presence of a recessionary gap?

Answer 15

Suppose wages (and other factor prices) fell quickly in response to the recessionary gap. The AS curve would therefore shift quickly downward as the lower wages led to reduced unit costs.

If wages fell rapidly in the presence of a recessionary gap, such wage flexibility would provide an automatic adjustment process that would push the economy back quickly toward potential output.

Question 16

What happens to the AS curve if wages are downwardly sticky?

Answer 16

If wages are downwardly sticky, the economy’s adjustment process is sluggish and thus will not quickly eliminate a recessionary gap.

Question 17

What does the weakness of an adjustment process following a negative demand shock mean?

Answer 17

The weakness of the adjustment process following a negative demand shock does not mean that recessionary gaps must always be prolonged. Rather, this weakness means that speedy recovery back to potential output must be generated mainly from the demand side.

This often happens when private-sector demand revives and the AD curve starts shifting back to the right. But it also raises the possibility that government stabilization policy can be used to accomplish such a rightward shift in the AD curve.

This is an important and contentious issue in macroeconomics, one to which we will return often throughout the remainder of this book.

Question 18

The difference in the speed of adjustment of wages is the important asymmetry in the behaviour of aggregate supply that we noted earlier in this chapter. This asymmetry helps to explain two key facts about the Canadian economy…

Answer 18

First, high unemployment can persist for quite long periods without causing decreases in wages of sufficient magnitude to quickly remove the unemployment.

Second, booms, along with labour shortages and production beyond normal capacity, do not persist for long periods without causing increases in wages.

Question 19

What would happen to the AS curve if there were an increase in the world price of oil?

Answer 19

Suppose there is an increase in the world price of an important input, such as oil. An increase in the price of oil increases unit costs for firms and causes the AS curve to shift upward.

Real GDP falls and the price level increases—a combination often called stagflation.

The new short-run equilibrium is at point . With the opening of a recessionary gap, the economy’s adjustment process comes into play, though sticky wages reduce the speed of this adjustment.

Question 20

What is stagflation?

Answer 20

Real GDP falls and the price level increases—a combination often called stagflation.

Question 21

What does the adjustment process from a negative AS shock look like graphically?

Answer 21

Question 22

What does a negative AS shock caused by an increase in input prices cause?

Answer 22

A negative AS shock caused by an increase in input prices causes real GDP to fall and the price level to rise. The economy’s adjustment process then reverses the AS shift and eventually returns the economy to its starting point.

The economy begins at point E0 in part (i). The rise in input prices increases firms’ unit costs and causes the AS curve to shift up to AS1 . Real GDP falls to Y1 and the price level rises to P1.

Question 23

What dose the excess supply of factores (Caused by a negative AS shock) do to wages and other factor prices?

Answer 23

A recessionary gap is created. In part (ii), the excess supply of factors associated with the recessionary gap causes wages and other factor prices to fall, possibly slowly.

As factor prices fall, unit costs fall and so the AS curve shifts back down to .

The eventual effect of the AS shock, after all adjustment has occurred, is to leave the price level and real GDP unchanged.

Question 24

What does a recessionary gap caused by a negative AS shock cause firms to do?

Answer 24

In our macro model, the recessionary gap caused by the negative supply shock causes firms to reduce output and trim their workforce. Some workers are laid off. The excess supply of labour (and other factors) eventually pushes wages down and begins to reverse the initial increase in unit costs caused by the increase in the price of oil.

Question 25

What happens as wages fall (due to a negative AS shock)?

Answer 25

As wages fall, the AS curve shifts back toward its starting point, and real GDP rises back toward its potential level, Y(*)

Since our model assumes that is constant, the reductions in factor prices eventually bring the economy back to its initial point, E0 . Note, however, that relative prices will have changed by the time the economy returns to .

The price level is back to P0 , its starting point, but real wages are lower while the relative price of oil is higher.

Question 26

In general terms, what do exogenous changes in input prices cause?

Answer 26

Exogenous changes in input prices cause the AS curve to shift, creating an output gap. The adjustment process then reverses the initial AS shift and brings the economy back to potential output and the initial price level.

Question 27

When is the economy said to be in long-run equilibrium?

Answer 27

Following any AD or AS shocks in our model, we have seen that the adjustment of factor prices continues until real GDP returns to . The economy is said to be in a long-run equilibrium when this adjustment process is complete, and there is no longer an output gap. In other words, the economy is in its long-run equilibrium when the intersection of the AD and AS curves occurs at Y* .

Question 28

What kind of variables do we say potential output depends on?

Answer 28

We also assume in our macro model that the value of Y* depends only on real variables, such as the labour force, capital stock, and the level of technology.

We assume, in particular, that Y* is independent of nominal variables, such as the price level.

Question 29

What are different names we use for the vertical line that occures at potential output?

Answer 29

The vertical line at Y* that we have seen in our diagrams is sometimes called a long-run aggregate supply curve—the relationship between the price level and the amount of output supplied by firms after all factor prices have adjusted to output gaps.

This vertical line is also sometimes called a Classical aggregate supply curve because the Classical economists were mainly concerned with the behaviour of the economy in long-run equilibrium.4

Question 30

Why can it be useful to omit the AS curve from a diagram?

Answer 30

Shows an AD/AS diagram without the usual upward-sloping AS curve. It is useful to omit this curve if our focus is on the state of the economy after all factor prices have fully adjusted and output has returned to . We can use this diagram to examine how shocks affect the economy’s long-run equilibrium.

Question 31

What different things dose potential output and aggregate demand determine?

Answer 31

Potential output determines the long-run equilibrium value of real GDP; given Y*,

aggregate demand determines the long-run equilibrium value of the price level.

Question 32

In our macro model, how is GDP determined in the long? What is the role of AD?

Answer 32

In the long run, real GDP is determined solely by potential output; the role of aggregate demand is only to determine the price level.

Question 33

How does the result that changes in AD have no long run effect on real GDP form our perspective on potential output?

Answer 33

This strong result—that changes in aggregate demand have no long-run effect on real GDP—follows from the assumption in our macro model that potential output is independent of the price level and thus unaffected by AD shocks.5

Question 34

What are some assumptions we have made in our macro model that make it different from the real world?

Answer 34

In our macro model in this chapter we have been assuming that inflation is zero and labour productivity is constant, and so any change in nominal wages creates an equal change in firms’ costs. And in our model it is the changes in firms’ costs that lead to shifts in the AS curve as part of the wage-adjustment process.

Question 35

In the real world, how is unit labor cost effected by wage increase and decreases?

Answer 35

In reality, however, the changes in firms’ costs depend on more than just nominal wages. Unit labour cost is a measure of the labour cost required to produce one unit of output. Unit labour costs rise when real wages increase because workers are more expensive; but unit labour costs fall when labour productivity increases because workers are able to produce more output per hour.

Question 36

How can we compute the annual change in unit labour cost?

Answer 36

We can compute the annual change in unit labour cost by starting with the growth rate of nominal wages and then subtracting the rate of inflation and the growth rate of labour productivity.

Question 37

How does real Canadian data reflect in our macro modes key assumption relating output gaps and wages?

Answer 37

Canadian data confirm our macro model’s key assumption that positive output gaps tend to drive wages and costs upward while negative output gaps tend to drive wages and costs downward.