Chapter 25: Aggregate Demand, Aggregate Supply and Modern Macroeconomics
Questions for Thought and Review
1. The central difference between activist and laissez-faire economists is their differing views about whether the economy is self-regulating. Laissez-faire economists (Classicals) believe the pricing mechanism will bring the economy to an equilibrium (potential output and full employment) while activist economists (Keynesians) do not share that belief.
2. Classicals felt that if the wage was lowered, the Depression would end. They saw unions as preventing the fall in wages, and they saw the government lacking the political will to break up unions.
3. Five factors that ...view middle of the document...
7. This implies that productivity is increasing significantly. If computers are a large portion of the economy, and wages do not rise by the full amount of the productivity increase, the result will be to lower the SAS curve. It can also shift out the potential output curve to the right, increasing equilibrium potential output and lowering the price level.
8. Yes, they would emphasize the inherent value of the program rather than discussing the program’s effect on aggregate demand. This is because programs that increase aggregate demand when the economy is close to potential will ultimately lead to inflation and little increase in real output.
9. Countercyclical fiscal policy is difficult to implement because it is difficult to assess the condition of the economy at any one time, it takes a long time to enact new government policies, and politically it is difficult to raise taxes when the economy is doing well (or at any time). Often times politics, not the needs of the economy, guide tax and spending decisions.
10. To design an appropriate fiscal policy, it is important to know the level of potential output because where the economy is relative to potential tells you whether to implement expansionary or contractionary policy. Conducting fiscal policy without having an estimate of potential output would be like driving without being able to see the road.
11. As can be seen in the following diagram, a large increase in potential output (shifting the LAS curve to the right) would cause downward pressure on the price level from P0 to P1. As the price level shifts down the output level increases from Y0 to Y1. This is the argument some economists used to suggest policymakers didn’t need to worry about inflation.
12. The simple model abstracts from a number of important issues such as the problem of estimating potential income. Without knowing potential income, we cannot know whether expansionary or contractionary policy is called for. Also, the model does not take into account the difficulties in implementing fiscal policies and the uncertain effectiveness of those policies.
Chapter 25: Problems and Exercises
1. a. The SAS curve will shift up since wages rise by more than the rise in productivity.
b. The SAS curve will shift down since productivity rises by more than the rise in wages.
c. The SAS curve will shift up since wages rise and productivity declines.
d. The SAS curve will not shift since the wage increase is exactly offset by a productivity increase.
2. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was a Marshallian who saw economic models as an engine of analysis, not an end in themselves.
b. It fits in nicely with the “other things constant” assumption since the policy relevance follows only when one has eliminated that assumption and taken into account all the things held at the back of one’s mind.
c. It definitely was primarily in the art of economics since the...