Question

Use the following information to work Problems \(14-16\) According to the East Asia and Pacific Economic Update published by the World Bank in April 2015 the following factors have affected China's real GDP in 2015 Global economic recovery supports a moderate increase in China's exports. China benefits from a fall in the world price of oil Chinese government to cut excess capacity in heavy industry. U.S. firms to relocate their labor-intensive manufacturing industries to low-cost countries. Explain how each factor separately affect China's real GDP and the price level, starting from a position of long-run equilibrium.

Short answer

China's export increase boosts GDP and prices; lower oil prices boost GDP, cut prices; cutting excess capacity lowers GDP, raises prices; U.S. firms relocating decreases GDP and prices.

Step-by-step solution

Global Economic Recovery

The global economic recovery leads to an increase in demand for Chinese exports. This increase in exports boosts aggregate demand (AD) in China. The rise in AD in the short run will shift the AD curve to the right, increasing both the real GDP and the price level.

Fall in World Price of Oil

A fall in the world price of oil reduces the production costs for Chinese industries. Lower production costs increase aggregate supply (AS). The rightward shift of the AS curve in the short run leads to an increase in real GDP and a decrease in the price level.

Cutting Excess Capacity in Heavy Industry

The Chinese government’s efforts to cut excess capacity in heavy industry aim to reduce inefficiencies. In the short run, reducing excess capacity might lower aggregate supply (AS) due to reduced production capabilities. This will likely lead to a decrease in real GDP and an increase in the price level.

U.S. Firms Relocating to Low-cost Countries

When U.S. firms relocate their labor-intensive industries to low-cost countries other than China, demand for Chinese labor and production decreases. This results in a decrease in aggregate demand (AD), shifting the AD curve to the left, leading to a decrease in both real GDP and the price level.

Key concepts

aggregate demand

Aggregate demand (AD) is the total quantity of goods and services demanded across all sectors of an economy at a specific price level and time period. It consists of consumption, investment, government spending, and net exports (exports minus imports). AD can be influenced by various factors, such as changes in consumer confidence, government policy, and global economic conditions. When AD increases, real GDP and the price level typically rise, while a decrease in AD can lead to a reduction in real GDP and potentially lower prices. For example, a global economic recovery increases demand for Chinese exports, boosting AD and thus increasing both China's real GDP and the price level.

aggregate supply

Aggregate supply (AS) refers to the total output of goods and services that firms in an economy are willing and able to produce within a given time period, at different price levels. When production costs decrease, such as through a fall in the price of oil, AS increases because it becomes cheaper for firms to produce goods. This increase in AS shifts the supply curve to the right, resulting in higher real GDP and lower price levels. Conversely, reducing excess industrial capacity can decrease AS, leading to higher prices and reduced real GDP due to decreased production capabilities.

global economic recovery

A global economic recovery occurs when economies around the world emerge from a downturn and start growing again. This recovery increases international trade and demand for exports from major manufacturing countries like China. As global demand for Chinese products rises, China's aggregate demand increases. This shift causes China's AD curve to move to the right, leading to higher real GDP and increased price levels. Increased exports contribute to the economic growth, improving the country's overall economic health.

oil price effects

Oil prices significantly impact production costs and aggregate supply. A decrease in world oil prices lowers the costs for industries reliant on oil, such as manufacturing and transportation. This reduction in costs allows firms to supply more at every price level, effectively shifting the AS curve to the right. Consequently, real GDP increases because firms produce and sell more goods. In contrast, the price level typically decreases as lower production costs lead to lower prices for consumers.

industrial capacity

Industrial capacity refers to the maximum output that industries can produce with the current level of resources and technology. When the government cuts excess capacity in heavy industries, it might aim to reduce inefficiencies and promote more balanced growth. In the short term, this reduction in capacity can decrease aggregate supply as there are fewer production capabilities. The leftward shift in the AS curve generally results in lower real GDP and higher price levels, as there are fewer goods and services available in the market despite demand.

labor-intensive manufacturing

Labor-intensive manufacturing relies heavily on human labor rather than capital. When U.S. firms move their labor-intensive operations to other low-cost countries, it can decrease demand for Chinese labor and production. This reduction in demand shifts China's aggregate demand curve to the left, leading to lower real GDP and reduced price levels. While this might initially seem negative, it can encourage China to move up the value chain, investing in more capital-intensive and high-tech industries for sustainable long-term growth.