What Is The Relationship Between An Economy’s Production Possibilities Curve And Its Long-run Aggregate Supply Curve?

Homework, Chapters 9 and 10

Chapter 9

What is the relationship between an economy’s production possibilities curve and its long-run aggregate supply curve? Why is the long-run aggregate supply curve vertical?

A production possibilities curve represents a composition of goods and services produced in a given period. The long-run aggregate supply curve depicts the quantity of output that can be produced in an economy using all the resources. The relationship is thus positive as the maximum output is determined by utilisations of all available resources. Therefore, the aggregate supply curve is vertical because it shows the relationship between the price levels and quantity of firms output after domestic people have had time to make changes to their long term commitments or counterbalance them once the prices change.

Does inflation transfer wealth from lenders to borrowers? Why or why not?

Inflation is the rise of the average price levels in an economy. An unexpected inflation results in losses for lenders because the real money interest rates decline. Moreover, the loan amount borrowed reduces the value at the time of payment. For instance, when the borrower’s wages increase, at the time of repayment, if the borrower repays the loan with the extra money, the lender will suffer less interest because he/she will be paid the amount earlier owed. Inflation enables the borrowers to pay back the lender’s money that is less in worth than when it was borrowed.

Chapter 10

What impact would a change that shifts an economy’s production possibilities curve outward have on the long-run aggregate supply curve? How have improvements in computer technology affected production possibilities and the long-run aggregate supply curve? Explain.

The production possibilities curve will shift outward on the long-run aggregate supply (LRAS) curve when economic growth happens as a result of technological improvements and capital formation. The economy’s resources improve thus LRAS increases in the long run. An improvement in computer technology creates an increased potential output for goods and services, therefore, causing an increase in supply. The vertical LRAS curve shifts to the right.

9. How will (a) an unexpected 3 percent fall in the price level in the goods and services market differ from (b) 1 percent inflation when 4 percent inflation had been expected? What impact would (a) and (b) have on the real price of resources, profit margins, output, and employment? Explain.

The difference between the two cases is that with the unexpected 3% price fall, the market price levels for goods and services decline instead of the expected rise. The firms’ output and revenue will decrease but the costs will increase causing losses. Consequently, the 1% inflation instead of the expected 4% inflation will result to rise in prices but at a lower rate. The firms’ revenue will, therefore, increase in small proportion while the costs increase in larger proportions. Firms usually base the resources and employee wage contracts on the expected inflations. The unexpected 3% fall of prices in the market, when a 4% increase in inflation was expected would result in firms making losses. However, the one percent increase in inflation instead of the expected 4% would cause the firms in the economy to constrict their profit margins.

Suppose that an unexpectedly rapid growth in real income abroad leads to a sharp increase in the demand for U.S. exports. What impact will this change have on the price level, output, and employment in the short run in the United States? In the long run?

In the short run, an increase in demand for the U.S exports would lead to an increase in the net exports aggregate demand. At the current level, the increase in aggregate demand causes an excess demand condition in the U.S economy. As the excess demand prevails, the firms in the U.S economy increase their prices to increase their revenue and profit margins. The increased revenue induces the firms to increase their output thus the firms hire more workers to expand the outputs. The level of employment in the short run therefore increases. In the long run, the high-profit margins attract more firms thus increasing the aggregate supply. The rise in supply leads to a reduction in prices while the production of the firms reach equilibrium. Consequently, employment also reaches equilibrium and any further increase in demand only increases output temporarily.