ECO 106 ASSIGNMENT II – Aggregate demand and supply

ECO 106 ASSIGNMENT II – Aggregate demand and supply

A hard copy of the assignment should be handed in at the beginning of class. Homework should be typed. Handwritten work will be accepted if it is extremely neat and legible.

1. Assume that new data show that the unemployment rate fell in October compared to September and that spending is higher than previously thought, so consumers and firms get increasingly optimistic about the future. Assume that this leads to an initial increase in US consumer spending by $50 mill. and investment spending by $100 mill. The combined increase in consumer and investment spending will start a multiplier effect. If consumers spend 75% of any increase in income, what will the total effect on output be when taking the multiplier effect into consideration?
2. There were two major shocks to the US economy in 2007 leading to a severe economic slowdown. One shock was related to oil prices, the other was the slump in the housing market. This question analyzes the effect of these two shocks on GDP using the AD-AS framework.

a. Draw typical aggregate demand and short-run aggregate supply curves. Label the axis and curves, and mark equilibrium output and price by Y1 and P1 and the equilibrium point by E1.

b. Data taken from the Department of Energy indicate that the average price of crude oil in the world increased from $54.63 per barrel on Jan. 5, 2007, to $92.93 on Dec. 28, 2007. Would an increase in oil prices cause a demand shock or a supply shock? Redraw the diagram from part a to illustrate the effect of this shock by shifting the appropriate curve. Include the curves and equilibrium before and after the oil price change. Label the new equilibrium point E2, the equilibrium quantity Y2, and equilibrium price P2.

c. The Housing Price Index, published by the Office of Federal Housing Enterprise Oversight, calculates that US home prices fell by an average of 3.0% in the 12 months between Jan. 2007 and Jan. 2008. Would the fall in home prices cause a supply shock or demand shock? Use your diagram from part b to illustrate the effect of this shock by shifting the appropriate curve. Label the new equilibrium point E3, the equilibrium quantity Y3, and equilibrium price P3. (Note: You should now have a graph that includes all the curves and equilibria: E1, E2, and E3.)

d. Compare the equilibrium points E1 and E3 in your diagram for part c. What was the total effect of the two shocks on real GDP and the aggregate price level (increase, decrease, or indeterminate, i.e. you cannot determine whether it was up or down based on the information above.)? What happened to the unemployment rate going from E1 to E3?

(This is the same as Ch. 12, question 11 in the textbook, with some minor changes.)


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