Question

I. The government in a certain economy has offered all business significant investment tax credits. Firms as a result invest heavily in new capital equipment and households have taken mortgages to buy new homes.

1. Draw an aggregate-demand/aggregate supply diagram showing the short-run effect of the investment tax credits on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplied changes.
2. Now use the diagram that you have drawn from part (a) to show the new long-run equilibrium of the economy. (Assume here, there’s no change in the long run aggregate-supply curve.) Explain in words why the aggregate quantity of output demanded changes between the short run and the long run.
3. How might the investment boom affect the long-run aggregate supply curve? Explain.

II. Explain whether each of the following events will increase, decrease or have no effect on the long-run aggregate supply.

1. The discovery of iron ore deposits in the United States.
2. Intel invents a new and more powerful computer chip.
3. Congress raises minimum wage to $18.
4. The United States experience a significant decline in immigration.
5. The price of raw material sharply increases.

Answer 1

(I) We assume that economy is in long run and short run equilibirium. This means LRAS, SRAS and AD curve intersects at common point (e). We shall then understand how changes in the investment affect SR and LR equilibirium.

(a) Investment tax credit (Positive demand shock) is a tax policy to stimulate aggregate demand in the economy. It works by boosting investments and causing quantity of capital goods or investment goods to rise. They will further boost up production of goods and services in the economy. This will also cause unemployment level to decline in the economy. One thing should be noted that quantity supplied had also increased due to price rise as firms find it more profitable to supply more at high prices. Overall, as investment rises in the economy, the AD1 curve will shift righwards to AD2. This implies output and prices will rise in the short run to Y1 and P1 respectively. The equibirium is at point (1).

(b) We have seen above part that output and prices have increased in the short run due to positive demand shock. However, economy is producing greater than its potential output. The aggregate quantity of output demanded will change between SR and LR due to the price adjustments as such was not complete in the short run. We shall know that prices are sticky in the short run.

The prices and wages will adjust now. Since prices have increased in the economy. The workers will revise their expectation and demand firms new contract on the basis of new prices. This will raise cost for the firms and they will lay off the worker. The SRAS1 will shift leftwards to SRAS2. This process will continue untill, unemployment again adjust with natural level and economy again reaches it full employment output. However, due to leftward shift of SRAS, the price level have increased to P2 which is  more than the initial level in the economy.

(c) The investment boom raises the productive capacity of the economy. It shall lead to addition of more capital stock which will ultimately boost production and output. Thus, investment boom will shift the LRAS curve rightwards as economy will achieve it new natural level.

(II)

(a) The discovery of iron ore deposits in the US would boost the quantity of natural resouces in the US economy. The rise in level of resources will boost productive capacity of the economy and thus Shift the LRAS curve righwards. This also implies production function have increased or moved upwards in terms of solow model.

(b) Intel discovers a new and powerful computer chip. This means productivity will increase which will cause more output to be produced with same level of inputs. The LRAS will increase with this new discovery.

(c)Congress raises minimum wage to $18. This will have negative impact on the LRAS curve because rise in the minimum wage will raise the production cost of the firms. They will layoff the labor which will cause LRAS curve to shift leftwards. This indicates unemployment level rises in the economy.

(d) The US witness siginificant decline in the immigration. The decline in the immigration means decline in the labor supply force. This will cause output production to fall. The LRAS curve will decrease or shift leftwards.

(e) The price of raw material rises sharply. We should always note that such price change in the short run doesnot determine the shape of LRAS curve. The rise or fall of prices will affect the SRAS curve. There shall be no impact over LRAS curve.