Chapter 22 Homework Solutions 5. If the dollar increases in value relative to foreign currencies so that foreign goods become cheaper in the United States, what will happen to the position of the short-run aggregate supply curve? The aggregate demand curve? The appreciation of the dollar makes imports cheaper and exports more expensive. Since some American firms use imported intermediate goods, their costs will fall, yielding a rightward shift in the SRAS curve. The decreased demand for American output will cause the aggregate demand curve to shift left. There will be an unambiguous decrease in the price level and depending on the relative magnitudes of the two shifts, an increase in output (supply shifts more than demand), an increase in output (supply shifts less than demand), or no change in output (supply shifts by the same proportion as demand). 7. If huge budget deficits cause the public to think that there will be higher inflation in the future, what is likely to happen to the short run aggregate supply curve when budget deficits arise? If people expect that inflation will be higher in the future, they will demand higher wages today. This raises firm production costs, shifting the SRAS curve to the left. 8. If a pill were invented that made workers twice as productive but their wages did not change, what would happen to the position of the short run aggregate supply curve? An increase in labor productivity without a corresponding increase in wages means that firms are able to produce more output for the same costs, raising their profits. With higher profit margins, firms produce more output, shifting the SRAS curve to the right. 9. When aggregate output is below the natural level, what will happen to the price level over time if the aggregate demand curve remains unchanged? When output falls below full employment, the economy has available resources that are not being utilized. There is unemployment in labor markets and capital equipment is idle. When wage, rental, and price contracts are renegotiated, workers, capital owners, and suppliers will have to accept lower wages, rental rates, and prices. As a result, production costs fall and the SRAS curve will shift right until full employment output is restored. 12. Predict what will happen to aggregate output and the price level if the Federal Reserve increases the money supply at the same time that Congress implements an income tax cut? Both the monetary policy action of lower interest rates (increasing the money supply) and the fiscal policy action of cutting taxes are expansionary. They stimulate spending and will cause the AD curve to shift right. In the short run, this will yield an increase in both output and prices. However, output is above full employment, so in the long run, costs and prices will rise and output will fall back to full employment. 14. Proposals have come before Congress that advocate the implementation of a national sales tax. Predict the effect of such a tax on both the aggregate supply and demand curves and on aggregate output and the price level. If a sales tax replaced the income tax, there would be a greater incentive for savings. You only pay taxes on consumption, so the cost of consuming rises relative to the benefit of saving. This policy shift would cause the AD curve to shift in. In the short run, there will be a reduction in both price and output. In the long run, underemployment of resources will drive prices down even further as full-employment output is restored. There is also the possibility that the increase in savings today will yield an increase in potential (i.e. full employment output) in the future, as savings will be channeled into expanding the economy’s productive capacity. If this is indeed the case, then the short run effects will be the same as above, but in the long run, the economy will settle at an even higher output level and at even lower prices. This, of course, assumes that the government does not simply soak up the increase in savings to finance its budget deficits, which will surely increase since tax revenue must fall under any reasonable sales tax plan. 15. When there is a decline in the value of the dollar, some experts expect it to lead to a dramatic improvement in the ability of American firms to compete abroad. Predict what would happen to output and the price level as a result. In the short run, the depreciation of the dollar causes export prices to fall, raising the demand for American made products and shifting the AD curve to the right. There would also be an increase in the price of imports, causing production costs to rise and the SRAS curve to shift left. There is an unambiguous increase in price in the short run and assuming that the increase in demand exceeds the decrease in supply, an increase in output. In the long run, output above full employment will drive prices up, leading to a leftward shift in the SRAS curve back toward full employment.
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