Chapter 9: From the Short Run to the Long Run:

The Adjustment of Factor Prices

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Answers to Even-Numbered Study Exercises

Fill-in-the-Blank Questions
Question 2
a) inflationary; recessionary
b) unit; prices; upward (or to the left)
c) unit; prices; downward (or to the right)
d) slower; inflationary; wage stickiness

Question 4
a) potential output (Y*); price level
b) potential output
c) increase; increase
d) investment; AD; increase; investment; potential output

Review Questions
Question 6

a) See the figure below. The diagram shows the equilibrium at Y* and P0, as determined by the
curves AD0 and AS0. This economy is in long-run equilibrium because Y = Y* and thus there is no
pressure on factor prices to either rise or fall.

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 Chapter 9: From the Short Run to the Long Run: The Adjustment of Factor Prices 37

b) The reduction in the world’s demand for this country’s goods is a reduction in autonomous
expenditure. This is a negative aggregate demand shock, with the AD curve shifting to the left to
AD1. Real GDP falls to Y1 and the price level falls to P1.
c) At Y1, there is a recessionary output gap. Factors of production are used less intensively than
normal, and so there is excess supply of factors. This excess supply forces factor prices to fall,
thereby reducing firms’ costs and shifting the AS curve downward and to the right. The AS curve
shifts eventually to AS1, although due to sticky wages this adjustment may take quite a while. Real
GDP eventually returns to Y* and the price level stabilizes at P2.
d) If wages fall only slowly in response to excess supply, then the adjustment back to Y* will be
very slow. This means output will be below potential and unemployment will be above the natural
rate (or NAIRU) for an extended period of time. An alternative to waiting for this natural (and
slow) adjustment process is to shift the AD curve to the right through the use of an expansionary
fiscal policy. In this way, output can be returned to Y* more quickly. If wages were not sticky
downwards, the adjustment would be quick and there would be less of a role for such fiscal
stabilization policy.

Question 8
Consider personal and corporate income taxes separately.
Personal income-tax cuts can produce both a demand-side and supply-side stimulus. By increasing
households’ disposable income (for any given level of Y), the tax cut will increase desired
consumption and shift the AD curve to the right. One possible problem is that if the tax cut is viewed
to be temporary, households may not increase their desired consumption because they expect that
taxes will rise again in the near future. On the supply side, a cut in personal income-tax rates increases
the return to working (as opposed to leisure) and thus may increase the overall supply of labour. (By
reducing real wages, this would shift the AS curve to the right.) There is some debate about how
large this effect might be and also about how long it would take to fully take effect.

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38 Student Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

Reductions in corporate income-tax cuts can also generate both demand-side and supply-side effects.
By increasing the productivity of new investment, the tax cuts can stimulate firms’ investment
demand and thus provide a boost to aggregate demand – a rightward shift of the AD curve.
Reductions in corporate taxes also have the effect of reducing firms’ costs and thus lead them to
supply more output at any given price level – a positive aggregate supply shock.

Question 10
a) Yes, assuming that the number of unemployed workers eligible for EI benefits varies negatively
with real GDP (as it generally does).
b) No—the reverse is true. Expenditures fixed in nominal (dollar) terms are a built-in stabilizer in
times of rising price levels, since it leads to reductions in spending that tend to slow down the
inflationary forces. In contrast, cost-of-living escalators (which raise nominal pay-outs when prices
are rising) will act to destabilize those inflationary forces.
c) Yes, particularly if the income-tax system is progressive. Increases in real GDP will lead to
increases in taxes paid which act to dampen the income-induced increase in spending. Review the
material in Chapter 7 for more details.
d) One supposes that this will be a built-in stabilizer substituting production of university education
for transfer payments of welfare. But many might merely postpone university in order to get a “free
ride” 10 years later.

Problems
Question 12
a) The output gap is simply Y – Y*, where in this case Y* is $800 billion. See the completed table
below.

Situation Output Rate of AS curve

Gap Wage Shift?
Change
A –25 –2.0% Down
B –15 –1.2% Down
C –5 –0.2% Down
D 0 0.0% No shift
E 5 1.0% Up
F 15 2.4% Up
G 25 4.0% Up
H 35 5.8% Up

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 Chapter 9: From the Short Run to the Long Run: The Adjustment of Factor Prices 39

b) When Y > Y*, firms use factors more intensively than normal and so factor markets are in a state
of excess demand. This pushes wages and other factor prices up. When Y < Y*, firms use factors
less intensively and so factor markets are in a state of excess supply. This excess supply pushes
wages and other factor prices down.
c) A rise in factor prices increases firms’ costs and thus shifts the AS curve upward. A fall in factor
prices reduces firms’ costs and thus shifts the AS curve downward. See the completed table above.
d) See the figure below. Though the Phillips curve is not as smooth as the ones shown in the text,
note that an inflationary output gap of $25 billion leads wages to rise (point G) by more than a
recessionary output gap of the same size, which leads wages to fall (point A).

Question 14
a) The simple multiplier is equal to 1/(1-z) where z = MPC(1-t)-m.

Economy A: z = (0.84)(0.85) – 0.19 = 0.524  Simple multiplier = 2.1

Economy B: z = (0.84)(0.60) – 0.19 = 0.314  Simple multiplier = 1.46

Economy C: z = (0.93)(0.85) – 0.12 = 0.671  Simple multiplier = 3.04

Economy D: z = (0.75)(0.70) – 0.27 = 0.255  Simple multiplier = 1.34

Economy E: z = (0.75)(0.90) – 0.30 = 0.375  Simple multiplier = 1.6

b) For a given AD shock, the AD curve will shift more when the simple multiplier is larger. So
the economy that experiences the largest swings in GDP following AD shocks is Economy C,
whereas the one with the smallest swings is Economy D.
c) For a given AD shock, the simple multiplier determines the size of the horizontal shift of the
AD curve. But the short-run change in real GDP depends on this shift and also the steepness of
the AS curve. The steeper the AS curve, the smaller the change in GDP.

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40 Student Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

d) Economies A and B differ by the net tax rate. Economy B has a higher tax rate, and this leads
to a smaller simple multiplier. It follows that, in response to AD shocks, there is more automatic
stabilization in Economy B than in Economy A.
e) For a given shift of the AD curve, the short-run change in real GDP depends on the steepness
of the AS curve. The steeper the AS curve, the smaller the change in GDP.

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