P-Set Five Answers
Aggregate Supply
Economics 100b; Spring 1996; Brad DeLong
1. Briefly summarize (one sentence on each) three reasons why
businesses in the aggregate react to increases in total demand by
increasing their prices and increasing the quantities they
produce and sell (as opposed to increasing prices alone).
- Here are my favorite three reasons (there are many, many
others):
(a) A good deal of the prices that businesses pay are fixed in the
short run, so increases in demand increase profit margins on each
unit sold--hence they try to sell more units.
(b) Businesses have a very hard time telling whether an increase
in demand is the result of general inflation (in which case they
should raise prices and leave demand unaltered) or the result of
an increase in demand for their product or industry. So they split
the difference.
(c) All businesses have some market power--and so restrict output
to achieve a higher price than a perfectly-competitive market
would generate. An increase in demand increases the costs of
output restriction, hence such monopolistically-competitive firms
increase output.
2. What is the Phillips curve? What is the difference between the
original Phillips curve and the accelerationist
Phillips curve?
- The Phillips curve is a negative relationship between the rate
of inflation and the rate of unemployment; the original Phillips
curve argument was that this negative relationship was a
characteristic of the institutional structure of the economy; the
accelerationist Phillips curve recognizes that the negative
relationship between inflation and unemployment shifts around, and
is itself determined by the economy's expectations of inflation.
3. What is the difference between the short run and the long run
Phillips curve?
- In the short run, expectations of inflation are fixed and
there is a downward sloping relationship between inflation and
unemployment. In the long run expectations of inflation adjust:
you can fool all (or enough of) the people, but not all the time.
So in the long run the Phillips curve turns vertical: running a
higher rate of inflation does not get you a lower rate of
unemployment once expectations have adjusted.
4. When the economy experiences a positive "supply shock", does:
- inflation accelerate and unemployment rise--correct
- inflation decelerate and unemployment rise
- inflation accelerate and unemployment fall
- inflation decelerate and unemployment fall?
5. When the economy experiences a positive "demand shock", does:
- inflation accelerate and unemployment rise
- inflation decelerate and unemployment rise
- inflation accelerate and unemployment fall --correct
- inflation decelerate and unemployment fall?
6. Does the short-run inflation-unemployment Phillips curve for
the U.S. today lie:
- above and to the right of the curve for the 1970s
- below and to the right of the curve for the 1970s
- above and to the left of the curve for the 1970s
- below and to the left of the curve for the 1970s?
--correct, especially for the late 1970s, but I would argue that
it is true for the early 1970s as well
7. What is the principal determinant of the location of the
short run Phillips curve?
- The expected rate of inflation held by decision makers in the
economy (and the presence or absence of current supply shocks)
8. What is the principal determinant of the slope of the short
run Phillips curve?
- The microstructure of markets and decisions in the economy:
how much businesses raise prices and how much they increase output
in response to a shift in demand; in a phrase, the slope of the
aggregate supply curve.
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