Aggregate demand and aggregate supply answers to online review questions



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Chapter 27

AGGREGATE DEMAND AND AGGREGATE SUPPLY

ANSWERS TO ONLINE REVIEW QUESTIONS

2. False. Fiscal policy (which involves changing the level of government purchases or taxes) will shift the AD curve; however, changes in these variables in order to achieve other government goals, or changes in autonomous consumption spending, investment spending, net exports, or the money supply will also shift the AD curve.

4. The short-run aggregate supply curve depicts the idea that changes in real GDP cause changes in the price level. It slopes upward because a rise in GDP increases unit costs, thereby increasing the price level, and a fall in GDP decreases unit costs, consequently depressing the price level.

6. The economy’s self-correcting mechanism is the long-run adjustment process whereby the economy returns to full employment after a demand shock. When a demand shock pushes the economy away from full-employment, changes in the wage rate and the price level return the economy to full-employment. For instance, consider a negative demand shock that decreases GDP. Assuming that initially the economy operated at full-employment GDP, a decrease in GDP will cause wages to fall due to high unemployment. As wages fall, unit costs decrease and the price level decreases causing GDP to rise. When the economy returns to full-employment output, this process stops.



8. Since the long-run aggregate supply curve is vertical, fiscal policy has no effect on GDP in the long run. It can only affect the price level. This is consistent with the classical view of fiscal policy. The vertical long-run AS curve also supports the classical view of crowding out. Beginning at full-employment output, a rise in government purchases will have no effect on GDP. Therefore, private sector spending must fall by as much as government purchases increase. That is, complete crowding out occurs, just as the classical model predicts.

PROBLEM SET

2.

Initially, the economy is in equilibrium at points E, J, and S. A decrease in the money supply is illustrated as a shift of the money supply from MS1 to MS2; the interest rate rises. The higher interest rate causes aggregate expenditure to decrease, leading to a decrease in GDP. At any price level, equilibrium GDP has decreased, and thus the AD curve shifts to the left. If the price level remains unchanged, the economy will come to rest at points F, K, and T. The interest rate is higher, real aggregate expenditure is lower, and the AD curve has shifted to the left.

4.

Initially, the economy is at point E. If the money supply decreases, the interest rate begins to rise, and the aggregate expenditure line shifts downward. Real GDP at any price level declines, indicated by a leftward shift of the AD curve to AD2. In the short run, the economy comes to rest at point G, with a lower price level and a lower real GDP. But at point G, output is below the full-employment level, and unemployment is high. In the long run, wages will fall, pushing unit costs down and causing the AS curve to shift downward. The new long-run equilibrium is at point H, with equilibrium GDP equal to its initial, full-employment value, and a lower price level.

6. In the short run, unit costs decrease and the AS curve shifts downward. The price level falls, and real GDP rises, above full-employment GDP. If the policy is temporary, then—in the long run—the AS curve will return to its original position once the policy is no longer in force. But even if the policy is in force for an extended period of time, the AS curve will return to its initial position. In this case, because GDP is above full-employment GDP, wages increase, unit costs increase, and the AS curve shifts back upward. In either case, both equilibrium GDP and the price level return to their original values.

8. a.


If the Fed does nothing, the AS curve would eventually shift downward as unusually high unemployment drove the wage rate down, and the economy would reach a new equilibrium at point F.


b.


The Fed’s actions were designed to boost investment spending, which would shift the AD curve rightward to ADpost 2001, returning the economy to point E.

c. If the Fed did nothing then the price level would have fallen as the AS curve shifted downward. As it was, successful Fed action caused the price level to rise back to its initial level.


10. a.

A temporary decrease in nonlabor input prices would temporarily move the economy from point A to point B, as the AS curve temporarily shifts from AS1 to AS2.

b. If the decrease lasts for an extended period, the self-correcting mechanism will bring the economy back to full employment as wages rise, and shift the AS curve back up to AS1.

c. The Fed would reduce the money supply to move the economy away from point (B). This would shift the AD curve from AD1 to AD2, and the economy would end up at point C, rather than at point A.



MORE CHALLENGING

  1. The Fed countered the downward AS curve shift by increasing the money supply, which led to an increase in AD. Although the shift of aggregate supply put downward pressure on the price level, this was offset by the upward pressure on the price level from the increase in aggregate demand.


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