Exercise Set 12
EQUILIBRIUM GDP AND PRICES

I. Objectives

• To obtain equilibrium GDP and price level in the DD/SS framework (also known as the AD-AS Model)
• To explain why output and prices change
• To understand inflationary and recessionary gaps

II. Data

The figure below shows the state of the economy. Aggregate demand is denoted by DD, aggregate supply by SS, and Y^f represents potential output. P is the price level and Y is real GDP.

Note: DD is also referred to as AD (aggregate demand), SS is the same as SRAS (short-run aggregate supply), and Y^f is the same as LRAS (long-run aggregate supply).

III. Questions

1. In the figure above, can we conclude that the economy is currently at full employment? Explain.
2. Suppose, in the figure above, the government increases spending on defense and roads.
   1. Describe the likely effects on the economy. Provide a sketch.
   2. Will the economy experience an inflationary gap or a recessionary gap? Explain.
   3. The gap in the previous question will be eliminated through the self-correcting mechanism as follows: Over time, wages will [ rise / fall ] causing the SS curve to gradually shift [ left / right ] until the economy reaches full employment. Provide a sketch and an explanation.
3. The Keynesian policy in the previous question is an example of [ an expansionary / a contractionary ] fiscal policy. Explain. Provide another example of a fiscal policy with similar effects.
4. In the 1970s, the US economy experienced two severe oil crises.
   1. What were the reasons for the crises? [Hint: Events in the Middle East.]
   2. As a result of the oil shocks, the price of oil rose dramatically. Explain how this led to stagflation. Provide a sketch.
   3. In the last couple of years, oil prices have risen sharply again. However, unlike during the '70s, economic growth has remained robust with inflation remaining in check. How come?
5. The 1990s, especially the second half of the decade, were characterized by large gains in productivity, rapid economic growth and low inflation.
   1. Use the figure above to explain the phenomenon.
   2. Discuss the reasons for the robust gains in labor productivity.
   3. Generally, real wages tend to rise with productivity. Why?