8.1 The building blocks of neoclassical analysis
Review Activities
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Practice Problems
Problem 8.1.1: Draw the aggregate market in a state of long-run equilibrium. Be sure everything is labeled.
Answer: See video.
https://youtu.be/aznwZUYMXx8
NOTE: Similar to what was mentioned before problem 7.4.2, these problems are only templates and apply to any corresponding scenario from problem 7.4.1.
Problem 8.1.2: An economy is initially in a state of long-run equilibrium. Then, consumers become pessimistic about the future. The impact is expected to be temporary. Show the short-run impact on the aggregate market. How will price level, real GDP, and unemployment change? What is this situation called? Now, show how the economy, according to the Neoclassical School, returns to its potential level of real GDP. As compared to the very beginning of the problem (when the economy was initially in a state of long-run equilibrium), what has happened to the price level, real GDP, and unemployment?
Answer: See video for graph. There will be an inward shift of the AD curve. This will cause a decrease in the price level, a decrease in real GDP, and an increase in unemployment. This is called a contraction or a recession. But, then, companies will begin to take cost-cutting actions. This could include decreases in wages and input costs (less likely) but also layoffs, wage freezes, and benefit reductions (more likely). As companies begin to reduce costs, their profitability begins to return, and the SRAS curve begins to shift outward. It continues to shift outward until the economy returns to its potential GDP. Compared to the start of the problem, price levels have fallen, real GDP has returned to its potential level (they did fall earlier, but have since rebounded), and unemployment has returned to its original natural level (it did increase earlier, but has since decreased.)
https://youtu.be/BoJzTtA2gac
Problem 8.1.3: An economy is initially in a state of long-run equilibrium. Then, the tax rate on income is cut meaning that disposable income has increased. The impact is expected to be temporary. Show the short-run impact on the aggregate market. How will price level, real GDP, and unemployment change? What is this situation called? Now, show how the economy, according to the Neoclassical School, returns to its potential level of real GDP. As compared to the very beginning of the problem (when the economy was initially in a state of long-run equilibrium), what has happened to the price level, real GDP, and unemployment?
Answer: See video for graph. There will be an outward shift of the AD curve. This will cause an increase in the price level, an increase in real GDP, and a decrease in unemployment. This is called an expansion. But, then, faced with a higher cost-of-living, employees start to demand higher wages. Similarly, suppliers also demand higher prices as their costs increase. The higher cost of production leads to reduced profitability therefore causing the SRAS to shift inward. It continues to shift inward until the economy returns to its potential GDP. Compared to the start of the problem, price levels have increased, real GDP has returned to its potential level (it did increase earlier, but has since fallen), and unemployment has returned to its original natural level (it did fall earlier, but has since increased.)
https://youtu.be/e4JZzKKj73s
External Resources
Khan Academy: Long-run Adjustment
8.2 Policy considerations in the neoclassical school
Review Activities
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Practice Problems
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8.3 The great depression
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8.4 recovery from supply shocks
Review Activities
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Practice Problems
Problem 8.4.1: An economy is initially in a state of long-run equilibrium. A war has decreased agricultural output by 30%. The impact is expected to be temporary. Show the short-run impact on the aggregate market. How will price level, real GDP, and unemployment change? What is this situation called? Show how the economy will return to a state of long-run equilibrium according to the Neoclassical School.
Answer: See video for graph. There will be an inward shift of the SRAS. This will cause an increase in price level, a decrease in real GDP, and an increase in unemployment. This situation is called stagflation. The economy will return to its potential GDP when the supply shock is over. In this problem, that would be when the war ends and farming is able to resume.
https://youtu.be/SGB3p6TRr4U
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