1. List and explain the three reasons the aggregate-demand
curve is downward sloping.
The aggregate-demand curve is downward
sloping because: (1) a decrease in the price level makes consumers feel
wealthier, which in turn encourages them to spend more, so there is a larger
quantity of goods and services demanded; (2) a lower price level reduces the
interest rate, encouraging greater spending on investment, so there is a larger
quantity of goods and services demanded; (3) a fall in the U.S. price level
causes U.S. interest rates to fall, so the real exchange rate depreciates,
stimulating U.S. net exports, so there is a larger quantity of goods and
services demanded.
2. Explain why the long-run aggregate-supply curve is
vertical
The long-run aggregate supply curve is
vertical because in the long run, an economy's supply of goods and services
depends on its supplies of capital, labor, and natural resources and on the
available production technology used to turn these resources into goods and
services. The price level does not affect these long-run determinants of real
GDP.
3. What might shift the aggregate-demand curve to the left?
Use the model of aggregate demand and aggregate supply to trace through the
short-run and long-run effects of such a shift on output and the price level
The aggregate-demand curve might shift to
the left when something (other than a rise in the price level) causes a
reduction in consumption spending (such as a desire for increased saving), a
reduction in investment spending (such as increased taxes on the returns to
investment), decreased government spending (such as a cutback in defense
spending), or reduced net exports (such as when foreign economies go into
recession).
The figure below traces through the steps
of such a shift in aggregate demand. The economy begins in equilibrium, with
short-run aggregate supply, AS1,
intersecting aggregate demand, AD1,
at point A. When the aggregate-demand curve shifts to the left to
AD2, the economy moves
from point A to point B, reducing the price level and the quantity of output.
Over time, people adjust their perceptions, wages, and prices, shifting the
short-run aggregate-supply curve down to
AS2, and moving the economy from point B to point C, which is
back on the long-run aggregate-supply curve and has a lower price level.
4. What might shift the aggregate-supply curve to the left?
Use the model of aggregate demand and aggregate supply to trace through the
short-run and long-run effects of such a shift on output and the price level
The aggregate-supply curve might shift to
the left because of a decline in the economy's capital stock, labor supply, or
productivity, or an increase in the natural rate of unemployment, all of which
shift both the long-run and short-run aggregate-supply curves to the left. An
increase in the expected price level shifts just the short-run aggregate-supply
curve (not the long-run aggregate-supply curve) to the left.
The figure
below traces through the effects of a shift in short-run aggregate supply. The
economy starts in equilibrium at point A. The aggregate-supply curve shifts to
the left from AS1 to
AS2. The new equilibrium
is at point B, the intersection of the aggregate-demand curve and
AS2. As time goes on,
perceptions and expectations adjust and the economy returns to long-run
equilibrium at point A, because the short-run aggregate-supply curve shifts back
to its original position.
a.
Draw a diagram to illustrate the state of the
economy. Be sure to show aggregate demand, short-run aggregate supply, and
long-run aggregate supply.
b.
Now suppose that a stock-market crash causes
aggregate demand to fall. Use your diagram to show what happens to output and
price level in the short run. What happens to the unemployment rate?
A stock market crash leads to a leftward
shift of aggregate demand. The equilibrium level of output and the price level
will fall. Because the quantity of output is less than the natural rate of
output, the unemployment rate will rise above the natural rate of unemployment.
c.
Use the sticky-wage theory of aggregate supply to
explain what will happen to output and the price level in the long run (assuming
there is no change in policy). What role does the expected price level play in
this adjustment? Be sure to illustrate your analysis in a graph.
If nominal wages are unchanged as the price
level falls, firms will be forced to cut back on employment and production. Over
time as expectations adjust, the short-run aggregate-supply curve will shift to
the right, moving the economy back to the natural rate of output.
6.
Explain whether each of the following events will
increase, decrease, or have no effect on short-run aggregate supply.
a.
The United States experiences a wave of
immigration
When
the United States experiences a wave of immigration, the labor force increases,
so long-run aggregate supply shifts to the right.
b.
Congress raises the minimum wage to $10 per hour
When Congress raises the minimum wage to
$10 per hour, the natural rate of unemployment rises, so the long-run
aggregate-supply curve shifts to the left.
c.
Intel invents a new and more powerful computer
chip
When Intel invents a new and more powerful
computer chip, productivity increases, so long-run aggregate supply increases
because more output can be produced with the same inputs.
d.
A severe hurricane damages factories long the
East Coast.
When a severe hurricane damages factories
along the East Coast, the capital stock is smaller, so long-run aggregate supply
declines.
7.
In 1939, the U.S. economy not yet fully recovered
from the Great Depression, President Roosevelt proclaimed that Thanksgiving
would fall a week earlier than usual so that the shopping period before
Christmas would be longer. Explain what President Roosevelt might have been
trying to achieve, using the model of aggregate demand and aggregate supply.
8.
Explain why the following statements are false.
a.
“The aggregate-demand curve slopes down ward
because it is the horizontal sum of the demand curves for individual goods.”
The
statement that "the aggregate-demand curve slopes downward because it is the
horizontal sum of the demand curves for individual goods" is false. The
aggregate-demand curve slopes downward because a fall in the price level raises
the overall quantity of goods and services demanded through the wealth effect,
the interest-rate effect, and the exchange-rate effect.
b.
“The long-run aggregate-supply curve is vertical
because economic forces do not affect long-run aggregate supply.”
The statement that "the long-run
aggregate-supply curve is vertical because economic forces do not affect
long-run aggregate supply" is false. Economic forces of various kinds (such as
population and productivity) do affect long-run aggregate supply. The long-run
aggregate-supply curve is vertical because the price level does not affect
long-run aggregate supply.
c.
“If firms adjusted their prices every day, then
the short-run aggregate-supply curve would be horizontal.”
The statement that "if firms adjusted their
prices every day, then the short-run aggregate-supply curve would be horizontal"
is false. If firms adjusted prices quickly and if sticky prices were the only
possible cause for the upward slope of the short-run aggregate-supply curve,
then the short-run aggregate-supply curve would be vertical, not horizontal. The
short-run aggregate supply curve would be horizontal only if prices were
completely fixed.
d.
“Whenever the economy enters a recession, its
long-run aggregate-supply curve shifts to the left.”
The statement that "whenever the economy
enters a recession, its long-run aggregate-supply curve shifts to the left" is
false. An economy could enter a recession if either the aggregate-demand curve
or the short-run aggregate-supply curve shifts to the left.
9.
Suppose that the economy is currently in a
recession. If policymakers that no action, how will the economy change over
time? Explain in words and using an aggregate-demand/aggregate-supply diagram.
The figure below depicts an economy in a
recession. The short-run aggregate-supply curve is
AS1 and the economy is at
equilibrium at point A, which is to the left of the long-run aggregate-supply
curve. If policymakers take no action, the economy will return to the long-run
aggregate-supply curve over time as the short-run aggregate-supply curve shifts
to the right to AS2. The
economy's new equilibrium is at point B.
10.
For each of the following events, explain the
short-run and long-run effects on output and the price level, assuming
policymakers take no actions.
a.
The stock market declines sharply, reducing
consumers’ wealth.
When
the stock market declines sharply, wealth declines, so the aggregate-demand
curve shifts to the left, as shown in Figure. In the short run, the economy
moves from point A to point B, as output declines and the price level declines.
In the long run, the short-run aggregate-supply curve shifts to the right to
restore equilibrium at point C, with unchanged output and a lower price level
compared to point A.
b.
The federal government increases spending on
national defense.
When the federal government increases
spending on national defense, the rise in government purchases shifts the
aggregate-demand curve to the right, as shown in the figure. In the short run,
the economy moves from point A to point B, as output and the price level rise.
In the long run, the short-run aggregate-supply curve shifts to the left to
restore equilibrium at point C, with unchanged output and a higher price level
compared to point A.
c.
A technological improvement raises productivity
When a technological improvement raises
productivity, the long-run and short-run aggregate-supply curves shift to the
right, as shown in the figure. The economy moves from point A to point B, as
output rises and the price level declines.
d.
A recession overseas causes foreigners to buy
fewer U.S. goods.
When a recession overseas causes foreigners
to buy fewer U.S. goods, net exports decline, so the aggregate-demand curve
shifts to the left, as shown in the figure. In the short run, the economy moves
from point A to point B, as output declines and the price level declines. In the
long run, the short-run aggregate-supply curve shifts to the right to restore
equilibrium at point C, with unchanged output and a lower price level compared
to point A.