KING'S COLLEGE

ECONOMICS 020

ANSWERS to Problem Set

Macro Problem Set #1: Short-Run and Long-Run Equilibrium

G. Copplestone

1. (a) An increase in government expenditures will effect the AD curve shifting it outwards to the right. Assuming we start at a position of full employment (triple intersection with AD, SRAS and LRAS) then the new short run equilibrium (which is where the new AD intersects the SRAS curve) will result in a higher price level and higher level of real GDP. In fact, equilibrium real GDP (Y) will now exceed the full-employment level of real GDP (Y*) opening up an inflationary gap. This will place upward pressure on the wage rate in turn causing the SRAS curve to shift up to the left as wages increase until Y=Y* again (return to full employment equilibrium). The new long run equilibrium will result in a higher price level but the same level of real GDP as initially. (The relevant diagram to show this effect is on page 512 – Figure 22.12 – an increase in AD).

(b) If there is a decrease in planned investment spending then businesses have decided to invest less. Again, if we start from a full employment equilibrium then the decrease in planned investment will cause a leftward shift in the AD curve (a decrease in demand) resulting in a new short run equilibrium with a lower price level and a lower level of real GDP. Moreover, since real GDP has fallen we now have a recessionary gap which will place downward pressure on wages resulting in the SRAS curve shifting downward to the right until the recessionary gap disappears and Y=Y* again. The new long run equilibrium will result in a lower price level but the same level of real GDP as initially.

(c) If we start at a full employment equilibrium and then the world price of oil increases, then input prices have changed which will shift the SRAS curve only. The new SRAS curve will be shifted upwards to the left. This will result in opening up a recessionary gap with the new short run equilibrium having a higher price level and a lower level of real GDP. The recessionary gap places downward pressure on the wage rate and causes the SRAS curve to shift back to the right until the gap is closed. Ultimately, the new LR equilibrium will be identical to the original equilibrium except that one input price (oil) is higher and another input price (wages) are lower. The original level of price and real GDP persist in the new longrun equilibrium. (The relevant diagram for this is on page 513 – figure 22.13 – a decrease in Aggregate supply).