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Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
Chapter 25 Aggregate Demand and Aggregate Supply
Review Questions
2. False. Fiscal policy (which involves changing the level of government purchases and/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 captures 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.
10. Real GDP growth did not keep up with productivity in 2002 for two reasons. First, real GDP growth was unusually low because business investment had fallen (perhaps due to continuing global uncertainty after September 11, 2001, and because, due to high levels of investment during the 1990s, firms had caught up with the amount of capital they desired). Second, productivity growth did not slow down because firms were able to adjust their workforce more easily to fluctuations in production due to a greater reliance on part-time and temporary workers.
Problems and Exercises
2.
Initially, the economy is at points E, J, and S. When the money supply curve shifts 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.
Assume that the economy is initially in equilibrium at point E. A decline in investment spending will shift the AD curve leftward, leading to a lower price level and smaller GDP at the new equilibrium point F. If the price level were held constant, then GDP would fall even more, to point G.
6.
The increase in autonomous consumption shifts the AD curve rightward from AD1 to AD2, increasing both the price level and real GDP in the short run (from point A to point B). In the absence of government intervention, eventually the AS curve would shift leftward from AS1 to AS2, moving the economy to point C. In the long run, an increase in autonomous consumption would lead to a higher price level and no net change in real GDP.
8. a.
If the Fed did nothing, eventually the AS curve would have shifted back to its original position as unusually high unemployment would drive the wage rate down, and the economy would have returned to point E.
b.
The Fed’s actions were designed to boost investment spending, which would shift the AD curve rightward to ADpost 1991. If successful, the economy would reach a new equilibrium at point F.
c. If the Fed did nothing then the price level would have fallen as the AS curve shifted downward. As it was, the price level rose due to the Fed action.
10. a.
An increase in competition will shift the AS curve downward, from AS1 to AS2.
b.
After the initial increase in competition shifts the AS curve downward from AS1 to AS2, the Fed will cut interest rates in order to shift the AD curve rightward, from AD1 to AD2. The economy will reach a new equilibrium at point F, where the price level is once again P1. Real GDP increases from Y1 to Y2.
12. a.
A temporary decrease in nonlabor input prices will 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).
Challenge Questions
2. The Fed countered the downward AS curve shift by increasing the money supply, which led to an increase in AD. Although the downward AS curve shift put downward pressure on the price level, this was offset by the upward pressure on the price level from the increase in AD.
Economic Application Exercises
2. The diagram shows this relationship.