Question

For each of the following events, discuss the short run and the long run effects on output and price levels, assuming that the policymakers take no action

A) The stock market decreases sharply, reduce customer's wealth

B) The federal goverment increases spending on national defense

C) A technogical improvement raises productivity

Answer 1

Answer:-
a) With reduced wealth, consumers will reduce consumption which will shift the AD curve to the left. People will save more and spend less which reduces price level and output in the short run. During the transition from short run to long run, there will be a fall in the nominal wages which implies cost of production will fall. A rise in aggregate supply shifts the AS to right, reducing the price level further below. But the output reaches back to its full potential level.
b) When spending by governmet increases, it means aggregate expenditure rises and this will shift the AD curve to the right. This causes a hike in the price level and output in the short run. During the transition from short run to long run, there will be a rise in the nominal wages which implies cost of production will rise in tandem. A fall in aggregate supply shifts the AS to left, increasing the price level further further up. But the output falls so that it reaches back to its full potential level.
c) A permanent increase in the total factor productivity will increase the marginal product of labor so that the demand curve for labor shifts to the right. This increases the real wage rate temporarily. In the output market since the supply of output has increased, AS shifts to the right lowering the interest rate. However, as the income increases, consumption and investment also rises so that the AD also shifts to the right raising the interest rate
Hence, the net effect on the interest rate is uncertain. With real interest rate initially falling, labor supply can shift to the left lowering the wage rate so that real wage may fall. The final effect on the rea wage is also uncertain. However, output unambiguously rises, employment will rise too.