Chapter 27, Problem 1P

To determine

(a)

To explain:

The effect of an increase in government purchase in the short run on the given two diagrams.

Answer to Problem 1P

The effect of an increase in government purchase is shown on the diagrams below:

Explanation of Solution

Government purchase is a part of aggregate demand. When there is an increase in the purchase by the government, it boosts the aggregate demand of the economy. This is reflected in the rightward shift of the aggregate demand curve from AD1 to AD2 in the above diagram. This results in a new equilibrium point C in the diagram where both real GDP and price level are higher than that at point B. On the right-hand side diagram, the SRPC line shifts from SRPC2 to SRPC3 because as real GDP grows for each level of inflation rate unemployment falls. The new equilibrium point C is marked on SRPC3 line.

Economics Concept Introduction

Government purchase:

The goods and services bought by the government to undertake infrastructural developments and other developmental activities is referred as government purchase.

To determine

(b)

To explain:

The effect of reduced growth rate of money supply in the short run on the given two diagrams.

Answer to Problem 1P

The effect of decrease in growth rate of money supply is shown on the diagrams below:

Explanation of Solution

A reduction in the growth rate of money supply affects the aggregate demand negatively through the real balance effect. This leads to a leftward shift of the aggregate demand curve from AD1 to AD2. The new equilibrium point is established at point C, where both real GDP and price level are lower than that of the equilibrium point at B. Due to fall in real GDP, there will be rise in unemployment, and hence the SRPC line shifts rightward from SRPC2 to SRPC3. The new equilibrium point C is shown on the SRPC3 in the right-hand side diagram.

Economics Concept Introduction

Money supply:

The amount of money in the form of currency and other financial liquid instruments supplied in an economy over a specific time period is referred as money supply.

To determine

(c)

To explain:

The effect of an expected higher inflation in the short run on the given two diagrams.

Answer to Problem 1P

The effect of an expected higher inflation is shown on the diagrams below:

Explanation of Solution

If people expect that higher inflation is approaching, they will increase their consumption expenditure to ward off the high inflation. Therefore, the aggregate demand will rise in the short run. This is reflected in the rightward shift of the aggregate demand curve from AD1 to AD2 in the above diagram. This results in a new equilibrium point C in the diagram where both real GDP and price level are higher than that of point B. On the right-hand side diagram, the SRPC line shifts from SRPC2 to SRPC3 because as real GDP grows at each level of inflation rate, unemployment falls. The new equilibrium point C is marked on SRPC3 line.

Economics Concept Introduction

Inflation rate:

The rate at which the price level of an economy rises is termed as the rate of inflation. An increased inflation rate decreases the purchasing power of people in an economy.

To determine

(d)

To explain:

The effect of a favorable supply shock on the given two diagrams.

Answer to Problem 1P

The effect of supply shock is shown on the diagrams below:

Explanation of Solution

A favorable supply shock will push the supply of the economy upward, causing the aggregate supply curve shifting rightwards from SRAS2 to SRAS3. With no change in the aggregate demand, the new equilibrium is formed at point C where real GDP is more than the previous equilibrium level corresponding to point B, but the price level is lower than that of point B. On the right-hand side diagram, the SRPC line will shift leftward from SRPC2 to SRPC3 as a rise in real GDP will lower the unemployment at each level of the inflation rate. The new equilibrium point C is shown on SRPC3 line.

Economics Concept Introduction

Supply shock:

An event which leads to a sudden rise or fall in the supply of goods and services is referred as supply shock.