ECON Macro Canadian 1st Edition McEachern

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CHAPTER 10
AGGREGATE SUPPLY

ANSWERS TO END-OF-CHAPTER PROBLEMS

1.1 (Natural Rate of Unemployment) What is the relationship between potential output and the natural rate of
unemployment?
a. If the economy currently has a frictional unemployment rate of 2 percent, structural unemployment of 2
percent, seasonal unemployment of 0.5 percent, and cyclical unemployment of 2 percent, what is the
natural rate of unemployment? Where is the economy operating relative to its potential GDP?
b. What happens to the natural rate of unemployment and potential GDP if cyclical unemployment rises to
3 percent with other types of unemployment unchanged from part (a)?
c. What happens to the natural rate of unemployment and potential GDP if structural unemployment falls to
1.5 percent with other types of unemployment unchanged from part (a)?

a. Given the levels of the different types of unemployment, the natural rate of unemployment would be 4.5
percent, and the economy would have an actual real GDP below its potential GDP.
b. An increase in cyclical unemployment has no effect on the natural rate of unemployment or potential
GDP.
c. A decrease in structural unemployment results in a decrease in the natural rate of unemployment to 4.0
percent.

1.2 (Real Wages) In Exhibit 2 in this chapter, how does the real wage rate at point c compare with the real wage
rate at point a? How do nominal wage rates compare at those two points? Explain your answers.

The real wage at point c is exactly the same as at point a. The reason is simple. The output levels are the
same; if there has been no change in labour supply or demand, the real wage must also be the same. Note
that this is the equilibrium real wage and corresponds to potential output. There is no frictional
unemployment associated at this real wage.

The money wage at point a is higher than that at point c. The reason is that the rise in the expected price level
pushes up the money wage, thus decreasing short-run aggregate supply. In fact, the short-run supply curve
shifts to the left because the money wage increases.

2.1 (Expansionary and Recessionary Gaps) Answer the questions (a) through (f) on the basis of the following
graph:
a. If the actual price level exceeds the expected price level reflected in long-term contracts, real GDP equals
and the actual price level equals in the short run.
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b. The situation described in part (a) results in a(n) gap equal to .
c. If the actual price level is lower than the expected price level reflected in long-term contracts, real GDP
equals and the actual price level equals in the short run.
d. The situation described in part (c) results in a(n) gap equal to .
e. If the actual price level equals the expected price level reflected in long-term contracts, real GDP equals
and the actual price level equals in the short run.
f. The situation described in part (e) results in gap equal to .

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Chapter 10 Aggregate Supply C10-2

a. $1.42 trillion; 130

b. expansionary; $0.02 trillion
c. $1.37 trillion; 110
d. recessionary; $0.03 trillion
e. $1.40 trillion; 120
f. no output gap; $0 trillion

2.2 (Long-Run Adjustment) The ability of the economy to eliminate any imbalance between actual and potential
output is sometimes called self-correction. Using an aggregate supply and aggregate demand diagram, show
why this self-correction process involves only temporary periods of inflation or deflation.

When an expansionary gap exists (e.g., the economy is at point a), prices are higher than expected because
the expected price level is where the SRAS curve crosses the LRAS. Thus, upward pressure exists on nominal
wages, prices, and real wages until the economy moves to point b. Once point b is reached, prices stop rising
and hence the inflation is temporary.

When a recessionary gap exists (e.g., the economy is at point c), prices are lower than expected. This leads
to falling nominal wages, real wages, and prices temporarily until the economy reaches point d.

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Chapter 10 Aggregate Supply C10-3

3.1 (Changes in Aggregate Supply) List three factors that can change the economy’s potential output. What is
the impact of shifts of the aggregate demand curve on potential output? Illustrate your answers with a diagram.

Increases in resource availability, improvements in technology, or institutional changes that provide more
attractive production incentives increase long-run aggregate supply and, thus, potential output. In the
following diagram, the LRAS curve shifts to the right as a result of any of these changes.

If the aggregate demand curve shifts to the right in the following diagram, the price level increases but there
is no change in potential output or long-run aggregate supply. The LRAS curve stays at a potential output
of $8 trillion. Aggregate demand increases to AD, equilibrium moves from point a to point b, causing the
price level to rise and short-run output to increase to $8.2 trillion. The actual price level in the short run is
higher than expected and the level of output exceeds the economy’s potential of $8.0 trillion. Because the
short-run output exceeds the economy’s potential, there is an expansionary gap and upward pressure on the
price level. Eventually, the SRAS curve shifts left to SRAS due to rising price expectations. The equilibrium
moves from point b to point c. The SRAS curve has shifted left until the economy is back at the potential
output of $8.0 trillion.

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Chapter 10 Aggregate Supply C10-4

3.2 (Supply Shocks) Give an example of an adverse supply shock and illustrate graphically. Now do the same for
a beneficial supply shock.

A natural disaster is an example of an adverse supply shock. The graph is Exhibit 7 in the text.

Beneficial shocks would include technological breakthroughs or discoveries of natural resources and are
illustrated in the text in Exhibit 6.

SUPPLEMENTAL CASES, EXERCISES, AND PROBLEMS

Experiential Exercises

1. In the short run, some workers’ wages are determined by contracts, and some are not. The split between costs
that change as production changes and those that do not is a key determinant of the shape of the short-run
aggregate supply curve. To get a better feel for wage determination, have students look at the “Labour
Market” section of the Financial Post (see, for example, http://business.financialpost.com/tag/labour-market)
to determine how some of the developments described there are likely to affect aggregate supply. Make sure
that they distinguish between the short-run and the long-run effects. Ask them to draw a diagram to illustrate
their conclusions.

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Chapter 10 Aggregate Supply C10-5

Additional Questions and Problems

1. (Short-Run Aggregate Supply) In the short run, prices may rise faster than costs. This chapter discusses why
this might happen. Suppose that labour and management agree to adjust wages continuously for any changes
in the price level. How would such adjustments affect the slope of the aggregate supply curve?

Because some resource prices are fixed in the short run, increases in output do not cause the price level to
rise as fast as it otherwise might. However, if wages were indexed to movements in the price level, the short-
run aggregate supply function would have a greater slope, approaching that of the potential output curve.
Every time the price level rose, the resulting increase in wages would bring additional pressure to bear,
making it difficult to increase output without a substantial increase in prices. The main point to emphasize
here, as the text notes, is that the stickiness of some resource prices flattens out the short-run aggregate supply
curve.

2. (Potential Output) Define the economy’s potential output. What factors help determine potential output?

Potential output is the maximum output sustainable in the long run given the state of technology and the
quantity/quality of resources in the economy.

Many factors affect the potential output of the economy. The first is the economy’s stock of capital. An
economy with a large stock of plants and machinery will produce more than one with a smaller stock. Second,
we must consider the effect of the level of technology. The better the technology, the more output can be
produced from a given stock of resources. Along with technology, one should point out that the stock of human
capital in the economy is equally important. It is of no use to have computers and other sophisticated
technology if there is no one who can effectively use them. Third, the level of potential output will depend on
society’s stock of natural resources. Fourth, improved size or quality of the labour force would increase
potential output. Finally, the formal and informal institutions supporting the economy (such as types of labour
contracts, enforcement of property rights and contracts, political stability) have an important effect on
potential output.

3. (Actual Price Level Higher Than Expected) Discuss some instances in your life when your actual production
for short periods exceeded what you considered your potential production. Why does this occur only for brief
periods?

As a student, you study for long periods during exam week and exceed your normal study time. For a short
period of time, you can study for 14 to 18 hours per day. You could not keep up this pace for longer than a
brief period. This example is similar to the economy producing beyond its potential output for an extended
period of time. Triple shifts and overtime cannot go on forever; the employees become burned out.

4. (Nominal and Real Wages) Complete each of the following sentences:

a. The wage measures the wage in dollars of the year in question, while the
wage measures it in constant dollars.
b. Wage agreements are based on the price level and negotiated in terms.
Real wages are then determined by the_ price level.
c. The higher the actual price level, the is the real wage for a given nominal wage.
d. If nominal wages are growing at 2 percent per year while the annual inflation rate is 3 percent, then real
wages change by_ .

a. nominal; real
b. expected; nominal; actual
c. lower
d. 1 percent

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Chapter 10 Aggregate Supply C10-6

5. (Recessionary Gaps) After reviewing Exhibit 3 in this chapter, explain why recessionary gaps occur only in
the short run and only when the actual price level is below what was expected.

In the long run, the actual and expected price levels equal one another when potential output and actual
output are equal. Thus, there is no pressure on prices to rise or fall.

Recessionary gaps occur only when output is below its potential level and the price level is below its expected
level. If this is the case, nominal wages will be too high, giving rise to unemployment and below-potential
output. This in turn will produce pressure on labour and business to accept nominal wage cuts and lower
prices, respectively. In Exhibit 3 we have the case of a reduction in aggregate demand causing the actual
price level to be below that expected. This gives rise to an increase in aggregate supply and a change in
expected price from 105 to 100.

6. (Short-Run Aggregate Supply) In interpreting the short-run aggregate supply curve, what does the adjective
short-run mean? Explain the role of labour contracts along the SRAS curve.

The short run is the period during which the prices of some resources, especially labour, are fixed by implicit
or explicit contracts. Firms and those who supply resources have insufficient time to adjust to an unexpected
change in the price level.

Labour contracts may cause production costs to change more slowly than output prices. When output prices
rise, for example, some wages are fixed by contract. Thus, firms’ revenues would rise more rapidly than costs,
and increasing production leads to greater profits. Actual price increases lead to increased real output—and
therefore the aggregate supply curve slopes upward.

7. (Recessionary Gap) What does a recessionary gap imply about the actual rate of unemployment relative to
the natural rate? What does it imply about the actual price level relative to the expected price level? What
must happen to real and nominal wages in order to close a recessionary gap?

With a recessionary gap, unemployment exceeds the natural rate, and the actual price level is below the
expected price level. To close the recessionary gap, the real wage must fall. This requires the nominal wage
to fall or at least rise more slowly than output prices rise.

8. (Expansionary Gap) How does an economy that is experiencing an expansionary gap adjust in the long run?

In the long run, firms and workers realize that the actual price level exceeds the expected price level reflected
in long-term contracts. Actual unemployment falls below the natural rate of unemployment, and labour
shortages occur. When the resource payments are renegotiated, nominal wages and other resource prices
rise, and the short-run aggregate supply curve shifts to the left. The process continues until actual prices
equal expected prices, and the economy returns to potential output.

9. (Output Gaps and Wage Flexibility) What are some reasons why nominal wages may not fall during a
recessionary gap?

First, some workers operate with long-term contracts, so firms would need to wait for the contract to expire
before they could negotiate lower nominal wages. Second, the efficiency wage theory argues that firms keep
nominal wages above equilibrium in order to attract and retain workers. During recessions, firms prefer to
lay off workers and reduce the hours of remaining workers rather than cutting wages. Finally, unemployment
benefits reduce the incentive of workers to accept lower wages.

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Chapter 10 Aggregate Supply C10-7

10. (Long-Run Adjustment) In the long run, why does an actual price level that exceeds the expected price level
lead to changes in the nominal wage? Why do these changes cause shifts of the short-run aggregate supply
curve?

If the actual price level is above the expected level, contracts drawn up by workers and firms have set too low
a nominal wage. When the time for renegotiation of the wage comes around, workers will expect an increase
of the money wage to conform with the equilibrium real wage.

As the money wage increases, the short-run aggregate supply curve will shift to the left, returning output to
its potential level. The aggregate supply curve shifts because it is drawn assuming that at least some resource
prices are fixed. If the money wage increases, it becomes more profitable to contract output, and so the
aggregate supply curve shifts to the left.

11. (Long-Run Aggregate Supply) The long-run aggregate supply curve is vertical at the economy’s potential
output level. Why is the long-run aggregate supply curve located at this output rather than below or above
potential output?

Cyclical unemployment is a disequilibrium phenomenon that results from the lack of perfect foresight on the
part of firms and resource suppliers. Movements away from potential output can occur only in the short run
if there are no other disturbances to the system. Thus, the long-run aggregate supply curve should be vertical
at the economy’s potential level of output. To have the long-run aggregate supply curve vertical at any other
output level would imply long-lasting cyclical unemployment or a labour shortage.

12. (Long-Run Aggregate Supply) Determine whether each of the following, other things held constant, would
lead to an increase, a decrease, or no change in long-run aggregate supply:
a. An improvement in technology
b. A permanent decrease in the size of the capital stock
c. An increase in the actual price level
d. An increase in the expected price level
e. A permanent increase in the size of the labour force

a. Increase
b. Decrease
c. No change
d. No change
e. Increase

13. (Changes in Aggregate Supply) What are supply shocks? Distinguish between beneficial and adverse supply
shocks. Do such shocks affect the short-run supply curve, the long-run supply curve, or both? What is the
resulting impact on potential GDP?

Supply shocks are unexpected events that change aggregate supply, in contrast to gradual long-term changes
that often occur due to population changes. Beneficial supply shocks increase aggregate supply, while adverse
supply shocks decrease it. Supply shocks can generate either temporary or permanent changes in aggregate
supply. Temporary changes (such as an isolated drought that affects agricultural yields) mean that only the
short-run aggregate supply curve is affected; permanent changes (such as a sudden leap in technology) are
reflected by shifts in both the short-run and long-run aggregate supply curves. Temporary changes have no
impact on potential GDP, but permanent changes cause potential GDP to increase with a beneficial shock
and decrease with an adverse shock.

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Chapter 10 Aggregate Supply C10-8

ANSWERS TO CASE STUDIES

10.1 Why Has Unemployment Been So High in Europe?

1. European unemployment is a hot topic. Use any Web browser to search for the words “European
unemployment.” Just by scanning the headlines, see how many possible explanations you can list. How do
they compare to the explanations reviewed in the chapter case study?

Answers will vary.

This case is available to students online at http://www.nelson.com/econmacro1e.

10.2 What Is the Canadian Natural Rate of Unemployment?

1. Explain how reducing the labour force participation rate reduces the natural rate of unemployment. Also
explain how increasing the rate of technological change has the same effect. What are the implications of this
for public policy?

Reducing the labour participation rate reduces the unemployment rate by reducing the number of individuals
potentially searching for work whilst being unemployed. This reduces the number of individuals who are
listed as officially unemployed and thereby the unemployment rate based on the formula used to calculate the
unemployment rate (unemployed)/(unemployed + employed). Increasing the rate of technological change
increases the efficiency of labour. This allows for more workers (in terms of hours worked) to be employed
at given real wage rates. Increasing employment, all other things remaining the same, reduces the
unemployment rate. If the natural rate of unemployment is reduced, then government could effectively use
monetary and fiscal policy to increase aggregate demand so that employment is consistent with the lower
natural rate of unemployment.

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