Chapter 12 Part 2
Summary – Shocks to the Economy
An economy can experience different types of shocks:
Þ Demand shocks – shifts of the AD curve.
Þ Supply shocks
Shifts of the SRAS curve
o A negative SRAS shock will lead to stagflation.
Simultaneous shifts of SRAS & LRAS curves
Summary – Stabilization Policy
They are public policies aimed at reducing the fluctuations in output in the
short run, i.e., keeping Y close to YFE in the short run.
Policy markers can use:
Þ Fiscal policy – the government’s choice regarding levels of spending,
taxes, and transfer payments.
Þ Monetary policy – the central bank’s choice regarding the level of money
supply. A change in money supply causes interest rate to change, which
will lead to a change in autonomous expenditure (because it affects the
costs of planned investment and current consumption).
Stabilization policy can fully offset demand shocks.
Policy makers will face difficult choices when the economy experiences
negative supply shocks.
MGEA06 Week 7 (Live Lecture) 1
Problems
Question 1: “Consider a closed economy that can be described by the AS-AD
model and the economy is initially in its long-run equilibrium. Due to supply
chain challenges, the price of oil increases by 20%. To keep output from
changing in the short run, the government can increase transfer payments to
households.” True/False/Uncertain, explain.
P LRAS
SRAS0
P0 A
AD0
Y
YFE
MGEA06 Week 7 (Live Lecture) 2
Question 2: “Consider a closed economy that can be described by the AS-AD
model and the economy is initially in its long-run equilibrium. If there is an
increase in the minimum wage, the government should increase (lump-sum)
taxes if they want to keep the aggregate price level from changing in the short
run.” True/False/Uncertain, explain.
P LRAS
SRAS0
P0 A
AD0
Y
YFE
MGEA06 Week 7 (Live Lecture) 3
Question 3: The Canadian government proposed to increase the corporate
capital gains tax inclusion rate from 50% to 66.67% on capital gains realized on
and after June 25, 2024. Once the proposed change comes into effect, what
happens to the short-run level of employment? Explain.
P LRAS SRAS0
P0 A
AD0
Y
YFE
MGEA06 Week 7 (Live Lecture) 4
Question 4: The economy is initially in its long run equilibrium and suppose
there is a major downward adjustment in the stock market. If the central bank
decides to accommodate the change, what happens to the long-run price level?
Explain.
P LRAS SRAS0
P0 A
AD0
Y
YFE
MGEA06 Week 7 (Live Lecture) 5
Question 5: Suppose an economy can be characterized by the AS-AD model:
Planned AE: AEPlanned = 300 – P + 0.75Y
SRAS: P = ( 20 + 0.1Y ) (W100 )
a) Find the long-run equilibrium levels of wages and price if the full-
employment level of output is 800.
Step 1: Derive the AD function by equating Y to AEPlanned
Step 2: Solve for P from AD by substituting Y = YFE into AD
Step 3: Solve for W from SRAS by substituting Y = YFE & P* into SRAS
MGEA06 Week 7 (Live Lecture) 6
b) Now, suppose there is a fall in housing prices such that autonomous
consumption falls by 70. Find the short-run equilibrium level of output.
Step 1: Derive new AD function.
Step 2: Solve for new SR equilibrium by equating AD to SRAS(W = 100).
MGEA06 Week 7 (Live Lecture) 7
c) Suppose the government finds the change in output in part (b) undesirable
and wants to keep it at the full-employment level by changing government
spending. Find the change in the government spending (G) that would
achieve the goal.
P LRAS SRAS(W = 100)
P0 = 100 A
AD0
Y
YFE = 800
MGEA06 Week 7 (Live Lecture) 8
Supplementary Notes on how to solve for the change in G
Note: This page is for those who want to understand the mathematics behind in solving for G on page
12. You can use your economics to solve for G or use the math below. It does not matter which
method used, if you do it right you will get the right answer and receive full credit.
The AD equation in generic form:
P = AE0 – ( 1 – MPC )Y, where AE0 = AC + AI + G + X 0 – IM0 + MPC × TR0 – MPC × T0 – d
×i
Let AE10 ( AE10 = AE00+ G = 230 + G) be the new value of AE0 that will shift the AD curve from AD 1
back to AD0 such that Y is at the targeted level of Y, (i.e., YFE in this case).
Þ This means the new AD equation would look like:
1
P = AE0 – ( 1 – MPC )Y = AE10 – 0.25Y, where = 1 Eq (1)
Step 1: From the SRAS equation, we find that level of price that will keep Y at Y FE (i.e., point A on
SRAS).
SRAS: P = ( 20 + 0.1Y )(W100 )
P = ( 20 + 0.1 × 800 ) (
100 )
100
P* = 100
Step 2: Find the value of AE10 from the new AD equation, Eq (1) that will keep Y at YFE.
Eq (1): P = AE10 – 0.25Y
100 = AE10 – 0.25 × 800
1
AE0 = 300
Step 3: Solve for the change in G (G).
1 0
AE0 = AE0+ G
G = AE10 - AE00
G = 300 – 230
G = 70 (G by 70)
MGEA06 Week 7 (Live Lecture) 9
