Answers to Review Questions

1.Explain the difference between aggregate demand and the aggregate quantity demanded of real output. Ceteris paribus, how is quantity demanded related to the overall price level?

Aggregate demand is the quantity of real goods and services that will be demanded at various price levels over a specific time period, whereas the quantity demanded of real goods and services is the amount that consumers plan to buy in a given period of time at a particular price. Aggregate demand is represented by the entire demand curve that shows various prices and quantities that will be demanded at those prices. Quantity demanded is a point on the demand curve showing one quantity that will be demanded at a specific price. Ceteris paribus, the quantity demand is inversely related to the overall price level.

2.Explain the wealth effect, the substitution-of-foreign-goods effect, and the constant nominal income effect.

The wealth effect occurs when the overall price level changes for a given nominal money supply; the supply of real money balances changes also and the consumer changes his/her spending because they are wealthier or poorer. If the overall price level rises and the supply of nominal money balances is constant, the supply of real money balances falls and the consumer is poorer and therefore spends less at the higher price level. If the overall price level falls for a given nominal supply of money, the supply of real money balances rises and the consumer is wealthier and therefore spends more at the lower price level.

The substitution‑of‑foreign goods effect occurs when the overall domestic price level changes while the foreign price level stays the same. When the domestic price level changes, domestic goods and services become relatively cheaper or relatively more expensive than foreign goods. Consumers substitute into relatively cheaper goods and out of relatively more expensive goods. Thus, when domestic prices fall, quantity demanded increases and vice versa.

The aggregate demand curve shows an inverse relationship between price and quantity demanded holding other factors including national income constant. The constant nominal income effect implies that if the price level changes, the quantity demanded must change in the opposite direction to maintain the constant nominal income.

3.What are the major sources of changes in aggregate demand? What are the short-run effects? The long-run effects?

The major sources of changes in aggregate demand include changes in taxes, government spending, the money supply, interest rates, expected inflation, the economic outlook, and exchange rates. Thus, both monetary and fiscal policy, among other things, affects aggregate demand.

The short‑run effects of a change or changes in the aggregate demand will result in the disturbance of equilibrium and cause the economy to either increase or decrease in output, price level, and employment. For example, in the short run, if aggregate demand increases, output prices, and employment all increase and vice versa.

The long‑run effects of a change in the aggregate demand will be a new set of equilibrium conditions that generally affect prices only.

4.What does investment spending consist of? How is investment spending related to the interest rate? Which is more volatile, consumption or investment? Which makes up a larger component of GDP?

Investment spending consists of purchases of new capital, changes in inventories and purchases of newly constructed residential housing. Investment spending is inversely related to the interest ratethat is, as one goes up, the other comes down and vice versa. Although investment is much more volatile than consumption, consumption makes up the much larger component of GDP.

5.Explain why only government purchases of goods and services, and not transfers, are a component of aggregate demand.

Government transfers are not considered a component of aggregate demand because they only shift purchasing power from one group to another without increasing or decreasing the level of aggregate demand.

6.What are net exports? How are they related to the exchange rate?

Net exports are the difference between exports and imports. Net exports are inversely related to exchange rates. As exchange rates rise, imports become cheaper and exports become more expensive. Therefore, imports increase while exports decrease, causing net exports to fall, and vice versa.

7.If prices and wages always change by exactly the same percentage and are expected to always do so, how is the short-run aggregate supply curve shaped? Make an argument that in this case, there is no such thing as a short-run aggregate supply curve. What is the real wage?

If prices and wages always change and are expected to always change by the exact same percentage, the short‑run aggregate supply curve will be a vertical line.

The short‑run aggregate supply curve is an upward‑sloping curve that shows a short‑term increase in output caused by increase in demand and the lagging of wages and input prices. As wages and price adjust to an increase (decrease) in demand, the short‑run aggregate supply curve will move leftward (rightward) back to the natural level of real output. When full adjustment is completed, only the upward (downward) movement of the overall price level will have changed. This upward (downward) movement creates a vertical long‑run aggregate supply curve. If the price and wages are expected to always change by the exact same percentage, then there will be no lagging between changes in wages and prices. Thus, there will be no short‑run aggregate supply curve.

The real wage is nominal wage divided by the overall price level. If prices and wages always change by exactly the same percentage, the real wage is constant.

8.What is the GDP deflator? The GDP deflator is a price index that

measures the overall changes in prices of everything included in GDP.

9.Can the natural level of real output ever change? If so, when? How is the natural level of real output related to the long-run aggregate supply curve?

Yes, the natural level of real output can change. The quantity and productivity of the factors of production determine natural level of real output. These factors include the economy's capital stock, natural resources, and labor force. Also, technology and the economic arrangement of the labor force affect it. When any of these factors change, the natural level of real output will also change.

The long‑run aggregate supply curve is vertical at the natural level of real output showing that in the long run, firms will supply the natural level of real output regardless of the price level.

10.How do price expectations affect the position of the short-run aggregate supply curve?

Price expectations can either shift the short‑run aggregate supply curve rightward or leftward. If the overall price level is expected to go up, there will be a leftward shift of the aggregate supply curve. If the overall price level is expected to go down, there will be a rightward shift of the short‑run aggregate supply curve.

11.What causes the short-run aggregate supply curve to shift left? Right?

The short-run aggregate supply curve will shift left whenever costs of production increase. The curve will shift right whenever costs decrease. A leftward shift is a decrease in aggregate supply while a rightward shift is an increase in aggregate supply. A technological breakthrough would cause the aggregate supply curve to shift rightward because the new technology is less costly.

Answers to Analytical Questions

12.Graphically illustrate the difference between a change in aggregate demand and a change in the aggregate quantity demanded of real GDP. Illustrate an increase in aggregate demand and an increase in the quantity demanded of real GDP.

On the graph above, a change in aggregate demand is shown as a shift of the aggregate demand curve, say from A to B or from A to C. A change in aggregate demand is caused by changes in monetary or fiscal policy or any other non-price factor that speeds up or slows down spending. A change in the quantity demanded of real GDP is shown as the movement along a curve from a to b on curve C. The change in quantity demanded is caused by a change in the overall price level.

13.Use aggregate supply and aggregate demand curves to explain what will happen to prices, output, and employment, ceteris paribus, in each of the following situations:

a. The government cuts spending. b. The Fed makes open market

purchases. c. Corporate tax rates are

increased. d. Interest rates abroad increase.

a. With cuts in government spending, output will fall, and the aggregate demand (AD) curve shifts leftward. As output falls, prices and employment also fall.

b. If the Fed makes open market purchases, output increases and the AD curve shifts rightward. As output rises, prices and employment rise.

c. If corporate tax rates increase, output will decrease and the SRAS curve will shift leftward. Prices and employment will also decrease.

d. If interest rates abroad increase, output will rise and the AD curve will shift to the right. Both prices and employment will also rise.

14.Why is the demand curve for wheat downward sloping? Why is the aggregate demand curve downward sloping? Explain why the reasons are different.

The demand curve for wheat is downward sloping because of the substitution effect. As the price of wheat falls while other prices are constant, wheat becomes relatively cheaper than other goods. Spending units substitute into relatively cheaper goods and out of relatively more expensive goods.

The aggregate demand curve is downward sloping because of the real‑balances effect, the substitution‑of‑foreign‑goods effect, and the constant nominal income effect. The overall price level is measured on the vertical axis of the aggregate demand curve rather than a relative price.

The aggregate demand curve and the demand curve for a specific good are thus downward sloping for different reasons. Whereas the relative price is measured on the vertical axis for the demand curve for a specific good, a price index is measured on the vertical axis for the aggregate demand curve. The price index shows changes in the overall price level.

15.Draw a short-run aggregate supply curve. Why is the curve upward sloping? What causes the short-run aggregate supply curve to shift?

The short-run aggregate supply curve is upward sloping showing a direct relationship between the overall price level and the quantity of real output that will be supplied. The curve is upward sloping because input price changes lag output price changes, causing quantity to respond in the short run to changes in the overall price level. Anything that changes the prices of the resources causes the short-run aggregate supply curve to shift. For example, if wages rise, the short-run supply curve shifts leftward and vice versa.

16.Use graphs to explain demand-pull inflation.

If aggregate demand increases, the aggregate demand curve shifts from AD to AD1 resulting in demand-pull inflation (higher prices). The increase in demand pulls the overall price level up.

17. Assume that the economy is originally in long-run equilibrium and that there is a drop in demand. Use graphs to explain how and why the economy initially moves to a short-run equilibrium with unemployment. How does the economy return to long-run equilibrium?

With a drop in demand, the aggregate demand curve shifts from curve B to curve D. The new short‑run equilibrium is at point E. At this point, both output and employment have fallen due to the drop in demand. If the policymakers do nothing, the economy will eventually return to long‑run equilibrium at point F when the prices are fully adjusted. The long‑run equilibrium (point F) will be at a lower price level on level on long‑run aggregate supply curve A, at the natural level of real output.

18.Graph a Phillips curve. Explain why the long-run Phillips curve is vertical. Could there be more than one short run Phillips curve? (Hint: Consider a change in price expectations.)

In the short run, there is a trade-off between inflation and unemployment. However, each short-run Phillips curve is associated with one expected price level. If price expectations change, the short-run Phillips curve shifts. If actual inflation is different from what was expected, this can trigger changes in expected inflation and shift the short-run Phillips curve. In the long run after full adjustment has been reached and actual values are equal to expected, there is no trade-off between inflation and unemployment. The long run Phillips curve is vertical at the rate of unemployment that corresponds with the natural rate of output.