5. A Decrease in the Budget Deficit

A reduction in government spending shifts the IS and AD curves to the left. As a result, output and the price level fall. The decline in the price level generates a (relatively) small downward shift of the LM curve, to make output in the IS-LM diagram consistent with output in the AD-AS diagram. As expectations adjust to the new price level, AS shifts down. The price level falls, but output begins to rise as the economy moves along the new AD curve. The AS curve continues to shift down until the economy reaches a new medium-run equilibrium with a lower price level, but the same level of output as in the initial equilibrium. In the IS-LM diagram, the reduction in the price level shifts the LM curve down until it intersects the new IS curve at the initial level of output, but a lower interest rate. With output at its initial medium-run level, but the interest rate lower, investment will rise relative to the initial medium-run equilibrium. The rise in investment exactly offsets the fall in government spending. In the short run, the effect on investment is ambiguous, since output falls (tending to reduce investment) and the interest rate falls (tending to increase investment).

6. Movements in the Price of Oil

The text models an increase in oil prices as in increase in , since higher energy costs increase the marginal cost of production, given the wage. The analysis of labor market equilibrium in Chapter 6 implies that the natural rate of unemployment will rise (the price-setting line will shift down), so the natural level of output will fall. Assuming that the economy begins in medium-run equilibrium, output will fall in the transition to the new medium-run equilibrium.

The AS relation in equation (7.1) implies that an increase in  increases the price level for any level of output, so the AS curve shifts up. The new AS curve (Figure 7.3) will intersect the vertical line above the new natural level of output ( Y_n') where the price level equals the expected price level (i.e., the original price level). As a result, in the new short-run equilibrium (point B in Figure 7.2), the price level has risen above the expected price level. Thus, the AS curve begins to shift up over time. The process continues until the AS curve intersects the original AD curve at the new natural level of output. In the new medium-run equilibrium (point C), output is lower and the price level is higher. In addition, in the IS-LM diagram (not shown), the increase in the price level reduces the real money supply and shifts the LM curve up, so the interest rate increases in the new medium-run equilibrium.

7. Conclusions

The exercises described in the chapter emphasize the distinction between the short-run and medium-run effects of shocks to the economy. Such shocks can arise from changes in private behavior or from policy changes. The dynamic effects of shocks are called propagation mechanisms. Fluctuations in output (commonly called business cycles) arise from the constant appearance of new shocks.