Question

For each problem analyze the effects in the Goods and Services market.

For problems #1 to #3 assume the economy initially begins at a long-run equilibrium.

1. Suppose international oil prices temporarily decrease.

a) Given the various shifters discussed in class, which curve shifts first and why? Show the graph of the Goods and Services market, including the shift.

b) What happened to the price level and RGDP in the short-run? What type of business cycle did this cause?

c) Over time, if this is just a temporary change that eventually reverses itself, what subsequent shift will occur? Indicate this shift using your graph given above. What is the ultimate longrun effect on the Deflator and RGDP?

2. Suppose the amount of buildings and machinery in the U.S. decreases.

a) Which curve(s) shifts and why? Graph the Goods and Services market including the shift(s).

b) What happened to the price level and RGDP?

c) Will this cause a temporary business cycle? Why or why not?

3. Suppose the Fed increases interest rates in the country.

a) Which curve shifts first and why? Graph the Goods and Services market, including the shift.

b) What happened to the price level and RGDP in the short-run? What type of business cycle did this cause?

c) Over time, what will eventually happen to resource costs given the above scenario?

d) From your answer in part c, what subsequent shift will occur? Indicate this shift using your graph given above. What is the ultimate long-run effect on the Deflator and RGDP?

Answer 1

1. a) A decrease in oil prices will decrease input costs for various goods and services. Oil is essential for running capital and transport service which is part of input cost of every firms. As input costs decrease, there is a increase in short run aggregate supply. The SRAS curve shifts to the right due to fall in input prices.

b) The rightward shift in the SRAS curve allows more ouput to be produced at any given price level. The result is an increase in real GDP and fall in price levels.

The economy has entered a business cycle chaterectized by an increase in output due to falling input costs. Thus the economy has entered a expansion phase in the business cycle.

c) If this event is temporary then there is no decrease in input costs in the long run, the LRAS will remain unaffected. The short run expansion of output will theoriticaly increase employment levels. This decrease in unemployment will lead to higher wages because of high competiton for wages in long run (when wages are not rigid and fixed). Once wages adjust (rise) in long run, the SRAS decreases and shifts left and returns to the initial position. hence in long run there is no effect on real GDP and price as they return to the initial level.