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Role of Automatic Stabilizers Assignment

Question 1

Aggregate supply curve shows the relationship between the price level and the real GDP supplied in the economy.

(i) Under what circumstances will the as curve have a flat segment?

figure.jpg

Figure 1.1 shows the three stages of the Aggregate supply curve.

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Solution:

Aggregate supply is the relationship between quantity of commodities, services and price. In the graph above, then Keynesian phase which is the first stage is also known as the short-run aggregate supply. At this point, the AS curve is almost horizontal.

At this stage, a company/firm will have two factors of production, that is, labor and capital. In the short run, they can only increase the labor because capital will include buildings and machinery which will take long to implement. It is also worth noting that the wages are static at this point and increase in labor will cause an increase in the quantity of production but not price. These are the reasons why the AS curve in the short run is almost horizontal/flat.

ii) When the economy has a vertical AS curve?

This is the final stage of the AS curve and is also known as the long run stage.

At this stage, there's an assumption that the wages, labor and capital are all controllable factors. Also, an improvement in the technological approach can be incorporated. The latter will increase the production levels while holding capital and labor constant due to the efficiency of the production process. The curve will therefore be almost a vertical line as shown in the figure 1.1 above (classical).

iii) The intermediate region is the one that links the horizontal and the vertical segments. It is also known as the medium run aggregate supply. This is the level at which you can alter capital in quantity. Assuming that it will take time to give the laborers an increment in the wages, their wages will be increased but slowly hence the upward sloping tendency of the curve at the intermediate level.

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Question 2: Write a one-page essay on the role of automatic stabilizers. In your essay include comments on the following points:

What are automatic fiscal stabilizers? How do these stabilizers stabilize real GDP in the face of AD and AS shocks?

What is the role of the simple multiplier [ 1/{1 - MPC(1 - t) - m}] in stabilization of the swings in real GDP?

How the slope of the AD curve affects the stability of real GDP in the presence of AS shocks?

How the automatic stabilizers depend on the sizes of MPC, t, and m.

Answer

Automatic stabilizers are those features of tax and transfer systems that cools the economy down when it overheats and stimulate it when deteriorates or stagnate. At this juncture, we shall bring on board the automatic fiscal stabilizers under our discussion. These are those policies that tends to stifle, suppress or smother the economic cycle fluctuations in employment, income and other factors automatically without the government intervening. The automatic fiscal stabilizers are very important in smoothing and easing economic shocks and stabilizing economic downtimes. They kick in automatically and therefore are capable of bypassing political processes when they are operative. They are also very important in countering events in the economy preventing unexpected high growth rates of recessions. When AD shifts to the right, GDP increases, increase levels of income and also an increase in government revenues from tax are realized.

The multiplier =1/(1 -[MPC(1-t)-m]),

From the above formula, it can be deduced that the effect of the multiplier states that the current injection causes a large increase in the real GDP.

Shift in the AD curve will be realized when there are variations in the consumption, government expenditure through the purchase of commodities and services as well. Increase in the level of investments. Increase in all these components will shift the AD curve to the right while a decrease in the same will make a shift to the left.

The relationship between the automatic stabilizers and the MPC, t and m can be described as follows; stabilizer value and the multiplier are inversely proportional, this multiplier is positivelyassociated to the MPC and the ‘t' is negatively proportional to the ‘m'. It is also key to note that marginal tax rate is negatively related to the tax rates that are prevailing in the market.

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