1. First, let’s consider the basics of the AD/AS model. A. List and explain the three reasons why the AD curve is downward sloping. (3 points) B. Explain an important assumption behind the upward slope of the AS curve. (3 points) C. Explain the process through which an economy returns to long-run equilibrium in the AD/AS model when output is above full employment. You may use a graph to help you answer, but your answer should be in words the graph will not be graded. (4 points) D. Explain the process through which an economy returns to long-run equilibrium in the AD/AS model when output is below full employment. You may use a graph to help you answer, but your answer should be in words the graph will not be graded. (4 points) 2. Now, let’s apply your knowledge of the AD/AS model to predict the effect on economic variables (i.e., P, RGDP, interest rates, wages, savings and spending) of some events on the U.S. economy. Diagram the effect of the following events. Be sure to explain the effects in the short run and effects in the long run for each question, in words. To keep things clear, assume that in each case the economy starts out at long-run equilibrium. Labor unions become better organized, and this allows them to drive up wages in the short run in the U.S. (3 points) Tensions in South America dramatically increase the price of coffee. For the sake of argument, suppose coffee is an important input in many industries, including computer programming, transportation, and financial services. (3 points) C. The government increases both taxes and spending by $500 billion. The money is spent domestically. Hint: Be sure to provide a strict interpretation of the AD/AS model as part of your answer. (3 points) D. Suddenly, foreign countries sell great quantities of important inputs such as steel and computer chips at very low prices in this country. Hint: The long-run effect will depend on whether the price decrease is permanent or not. (3 points) E. Householdssignificantlyreducetheirspendingandstartsavingalarger portion of their income, leading to a decrease in interest rates. Hint: Think about another sector of the economy and how it might respond to lower interest rates and what effect this will have on the model. (3 points) 3. Everyone loves a tax cut. How will the short-run effects of a tax cut on the price level and on unemployment differ if the economy is in a recession from the effects if the economy is at full employment? (Hint: Examine the slope of the AS curve.) (5 points) 4. The economy is at full employment and an election is coming up. To make sure they’re all re-elected, various officials decide to increase government spending by $100 billion. Senator Graham says the money should be spent on improving education and transport systems. Senator Dole proposes building several very large Coast Guard training facilities in states that currently have none, including Kentucky, Nebraska, Nevada, and Arkansas. A. What is the major difference between the spending plans of Senator Graham and Senator Dole? (3 points) B. What effect would Senator Graham’s proposal have on the AD/AS model? Describe all shifts as well as the effects on short-run and long-run equilibrium change in output and the price level. (4 points) C. What effect would Senator Dole’s proposal have on the AD/AS model? Describe all shifts as well as the effects on short-run and long-run equilibrium change in output and the price level. (4 points)
Basics of AD/AS model
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