Chapter 29 Aggregate Demand and Aggregate Supply QUESTIONS

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1 Chapter 29 Aggregate Demand and Aggregate Supply QUESTIONS 1. Why is the aggregate demand curve downsloping? Specify how your explanation differs from the explanation for the downsloping demand curve for a single product. What role does the multiplier play in shifts of the aggregate demand curve? LO1 Answer: The aggregate demand (AD) curve shows that as the price level drops, purchases of real domestic output increase. The AD curve slopes downward for three reasons. The first is the interest-rate effect. We assume the supply of money to be fixed. When the price level increases, more money is needed to make purchases and pay for inputs. With the money supply fixed, the increased demand for it will drive up its price, the rate of interest. These higher rates will decrease the buying of goods with borrowed money, thus decreasing the amount of real output demanded. The second reason is the real balances effect. As the price level rises, the real value the purchasing power of money and other accumulated financial assets (bonds, for instance) will decrease. People will therefore become poorer in real terms and decrease the quantity demanded of real output. The third reason is the foreign purchases effect. As the United States price level rises relative to other countries, Americans will buy more abroad in preference to their own output. At the same time foreigners, finding American goods and services relatively more expensive, will decrease their buying of American exports. Thus, with increased imports and decreased exports, American net exports decrease and so, therefore, does the quantity demanded of American real output. These reasons for the downsloping AD curve have nothing to do with the reasons for the downsloping single-product demand curve. In the case of the dropping price of a single product, the consumer with a constant money income substitutes more of the now relatively cheaper product for those whose prices have not changed. Also, the consumer has become richer in real terms, because of the lower price of the one product, and can buy more of it and all other products. But with the AD curve, moving down the curve means all prices are dropping the price level is dropping. Therefore, the single-product substitution effect does not apply. Also, whereas when dealing with the demand for a single product the consumer s income is assumed to be fixed, the AD curve specifically excludes this assumption. Movement down the AD curve indicates lower prices but, with regard to the circular flow of economic activity, it also indicates lower incomes. If prices are dropping, so must the receipts or revenues or incomes of the sellers. Thus, a decline in the price level does not necessarily imply an increase in the nominal income of the economy as a whole. The multiplier acts on an initial change in spending to generate an even greater shift in the aggregate demand curve. (Figure 29.2) 2. Distinguish between real-balances effect and wealth effect, as the terms are used in this chapter. How does each relate to the aggregate demand curve? LO1 29-1

2 Answer: The real balances effect refers to the impact of price level on the purchasing power of asset balances. If prices decline, the purchasing power of assets will rise, so spending at each income level should rise because people s assets are more valuable. The reverse outcome would occur at higher price levels. The real balances effect is one explanation of the inverse relationship between price level and quantity of expenditures. The wealth effect assumes the price level is constant, but a change in consumer wealth causes a shift in consumer spending; the aggregate expenditures curve will shift right. For example, the value of stock market shares may rise and cause people to feel wealthier and spend more. A stock decline can cause a decline in consumer spending. 3. What assumptions cause the immediate-short-run aggregate supply curve to be horizontal? Why is the long-run aggregate supply curve vertical? Explain the shape of the short-run aggregate supply curve. Why is the short-run curve relatively flat to the left of the full-employment output and relatively steep to the right? LO2 Answer: The immediate short-run supply curve is horizontal because of contractual agreements. These contracts for both input and output prices imply that prices do not change along the immediate short-run aggregate supply curve. The long-run aggregate supply curve is vertical (at the full-employment or potential output) because the economy s potential output is determined by the availability and productivity of real resources, not by the price level. The availability and productivity of real resources is reflected in the prices of inputs, and in the long run these input prices (including wages) adjust to match changes in the price level. Firms have no incentive to increase production to take advantage of higher prices if they simultaneously face equally higher resource prices. The shape of the short-run supply curve is upsloping. Wages and other input prices adjust more slowly than the price level, leaving room for firms to take advantage of these higher prices (temporarily) by increasing output. Firms face increasing per unit production costs as they increase output, making higher prices necessary to induce them to produce more. To the left of full-employment output the curve is relatively flat because of the large amounts of unused capacity and idle human resources. Under such conditions, per-unit production costs rise slowly because of the relative abundance of available inputs. Additional resources are easily brought into production, as the suppliers of these resources (especially labor) are anxious to employ them and are happy to accept current prices. To the right of full-employment output the curve is relatively steep because most resources are already employed. Those resources that are not yet in production require higher prices to induce them, or generate higher per-unit production costs because they are less productive than currently employed inputs. Firms trying to increase production bid up input prices as they attempt to attract resources away from other firms. Even if the firm succeeds in pulling resources from another firm, the aggregate increase in output is minimal at best, as resources are merely shifted from one productive process to another. 4. What effects would each of the following have on aggregate demand or aggregate supply, other things equal? In each case use a diagram to show the expected effects on the equilibrium price level and the level of real output, assuming that the price level is flexible both upward and downward. LO3 29-2

3 a. A widespread fear by consumers of an impeding economic depression. b. A new national tax on producers based on the value-added between the costs of the inputs and the revenue received from their output. c. A reduction in interest rates at each price level. d. A major increase in spending for health care by the Federal government. e. The general expectation of coming rapid inflation. f. The complete disintegration of OPEC, causing oil prices to fall by one-half. g. A 10 percent across-the-board reduction in personal income tax rates. h. A sizable increase in labor productivity (with no change in nominal wages). i. A 12 percent increase in nominal wages (with no change in productivity). j. An increase in exports that exceeds an increase in imports (not due to tariffs). Answer: (a) AD curve left, output down and price level down (assuming no ratchet effect). (b) AS curve left, output down and price level up. (c) AD curve right, output and price level up. (d) AD curve right, output and price level up (any real improvements in health care resulting from the spending would eventually increase productivity and shift AS right). (e) AD curve right, output and price level up. (f) AS curve right, output up and price level down. (g) AD curve right, output and price level up. (h) AS curve right, output up and price level down. (i) AS curve left, output down and price level up. (j) AD curve right (increased net exports); AS curve left (higher input prices) 5. Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run? LO3 a. An increase in aggregate demand. b. A decrease in aggregate supply, with no change in aggregate demand. c. Equal increases in aggregate demand and aggregate supply. d. A decrease in aggregate demand. e. An increase in aggregate demand that exceeds an increase in aggregate supply. Answer: (a) Price level rises rapidly and little change in real output. (b) Price level rises and real output decreases. (c) Price level does not change, but real output increases. (d) Price level does not change, but real output declines. (e) Price level increases somewhat, as does real output. 6. Explain how an upsloping aggregate supply curve weakens the realized multiplier effect from an initial change in investment spending. LO3 29-3

4 Answer: An upsloping aggregate supply curve weakens the effect of the multiplier because any increase in aggregate demand will have both a price and an output effect. For example, if aggregate demand grows by $110 million as a result of increased in investment spending, this could represent an increase of $100 million in real output and $10 million in higher prices if the inflation rate averages 10 percent. The multiplier is weakened because some of the increase in aggregate demand is absorbed by the higher prices and real output does not change by the full extent of the change in aggregate demand. 7. Why does a reduction in aggregate demand in the actual economy reduce real output, rather than the price level? Why might a full-strength multiplier apply to a decrease in aggregate demand? LO3 Answer: A reduction in aggregate demand causes a decline in real output rather than the price level because prices are inflexible downward ( sticky ). If we assume prices are completely inflexible downward, then a reduction in demand is essentially moving leftward and the aggregate supply curve is flat (horizontal), which means reduced output at a constant price. To say prices are completely inflexible downward may be an exaggeration, but prices don t fall easily for several reasons: wage contracts, minimum wage laws, employee morale, fear of price wars and the menu cost notion. Without price changes to mitigate the effects of an aggregate demand change, the multiplier is at full strength. If price were flexible downward, the decrease in spending would lower prices, encouraging some individuals within the macro-economy to spend more, dampening the multiplier effects. 8. Explain: Unemployment can be caused by a decrease of aggregate demand or a decrease of aggregate supply. In each case, specify the price-level outcomes. LO4 Answer: The statement is true, although the magnitude of the effect on unemployment can vary considerably, particularly with decreases in aggregate demand. A decrease in aggregate supply will unambiguously increase the price level and reduce real output. With the decrease in output we would expect unemployment to rise. If the economy is operating above its full-employment output, a decrease in aggregate demand will have more modest effects on unemployment, having its strongest impact on the price level (reducing it). If aggregate demand falls while the economy is operating to the left of fullemployment output, the increases in unemployment will be more substantial, and the effects on the price level weaker. 9. Use shifts of the AD and AS curves to explain (a) the U.S. experience of strong economic growth, full employment, and price stability in the late 1990s and early 2000s and (b) how a strong negative wealth effect from, say, a precipitous drop in house prices could cause a recession even though productivity is surging. LO4 29-4

5 Answer: (a) While AD is increasing and shifting to right, AS is shifting rightward as well, because of productivity increasing and growing labor force. Thus, both output and employment can rise while price level remains constant. The equilibrium shifts rightward, not upward because AS and AD shift by similar magnitudes. (see Figure 29.11) (b) In this situation AD shifts left from AD 1 to AD 2 because of the precipitous drop in house prices while AS shifts right from AS 1 to AS 2 because productivity is surging. This causes prices to fall from P to P and output to fall from Q to Q, resulting in a recession. AS 1 AS 2 P 1 P 2 AD 1 AD 2 Q 2 Q In early 2001 investment spending sharply declined in the United States. In the 2 months following the September 11, 2001 attacks on the United States, consumption also declined. Use AD-AS analysis to show the two impacts on real GDP. LO4 Answer: Both events would be represented by a leftward shift in aggregate demand, and the initial declines in spending would be multiplied. (See Figure 29-2, shift from AD 1 to AD 3.) This would cause real GDP to drop and, assuming flexible prices, a drop in the price level. To the extent the drop in investment spending affected productivity, it could have either shifted AS left (if productivity dropped) or slowed the rightward movement of AS that occurred through much of the 1990s and into the early 2000s. 11. Last Word Go to the OPEC Web sitehttp:// and find the current OPEC basket price of oil. By clicking on that amount, you will find the annual prices of oil for the past 5 years. By what percentage is the current price higher or lower than 5 years ago? Next, go to the Bureau of Economic Analysis Web sitehttp:// and use the interactive feature to find U.S. real GDP for the past years. By what percentage is real GDP higher or lower than it was 5 years ago? What if, anything, can you conclude about the relationship between the price of oil and the level of real GDP in the United States? 29-5

6 Answer: Answers will vary depending on when this question is assigned. PROBLEMS 1. Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth and that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. Also assume that the economy s multiplier is 4. If household wealth falls by 5 percent because of declining house values, and the real interest rate falls by two percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level? In what direction and by how much will it eventually shift? LO1 Answers: rightward by $15 billion; rightward by $60 billion. Feedback: Consider the following example. Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth and that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. Also assume that the economy s multiplier is 4. If household wealth falls by 5 percent because of declining house values, and the real interest rate falls by two percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level? In what direction and by how much will it eventually shift? Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth. If household wealth falls by 5 percent because of declining house values the initial shift in aggregate demand will be to the left (decline in real GDP) by $25 billion ( = 5 (percent decline in wealth) x $5 (consumer spending for every 1% change)). Note the positive relationship between wealth and consumer spending. Also, suppose that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. If the real interest rate falls by two percentage points the initial shift in aggregate demand will be to the right (increase in real GDP) by $40 billion ( = 2 (percentage point decline in interest rate) x $20 (investment spending for every 1 percentage point change)). Note the inverse relationship between the interest rate and investment. The combined initial effect is a shift to the right of the aggregate demand curve by $15 billion. There is a decrease of $25 billion from consumer expenditure and an increase of $40 billion from investment expenditure, thus, the net effect is a positive $15 billion. Given that the multiplier is 4, the aggregate demand curve will shift to the right by $60 billion after the multiplier process works its way through the economy ( = 4 (multiplier) x $15 billion (initial net impact on aggregate demand). 2. Answer the following questions on the basis of the three sets of data for the country of North Vaudeville: LO2 29-6

7 a. Which set of data illustrates aggregate supply in the immediate short-run in North Vaudeville? The short run? The long run? b. Assuming no change in hours of work, if real output per hour of work increases by 10 percent, what will be the new levels of real GDP in the right column of A? Does the new data reflect an increase in aggregate supply or does it indicate a decrease in aggregate supply? Answers: (a) B, A, C; (b) 302.5, 275, 247.5, 220; an increase. Feedback: Consider the following data as an example. Part a: Which set of data illustrates aggregate supply in the immediate short-run in North Vaudeville? The data in B. The price level does not have time to adjust in the immediate short-run. Only output can change. Which set of data illustrates aggregate supply in the short-run in North Vaudeville? The data in A. The price level only has time to partially adjust in the short-run. Both the price level and output can change. Which set of data illustrates aggregate supply in the long-run in North Vaudeville? The data in C. The price level has time to completely adjust in the long-run. Only price will change. Part b: Assuming no change in hours of work, if real output per hour of work increases by 10 percent, what will be the new levels of real GDP in the right column of A? 29-7

8 To find the new level of output at each price level multiply the original values by 1.1. Price level 110: New output equals (=1.1 x 275) Price level 100: New output equals 275 (=1.1 x 250) Price level 95: New output equals (=1.1 x 225) Price level 90: New output equals 220 (=1.1 x 200) Does the new data reflect an increase in aggregate supply or does it indicate a decrease in aggregate supply? This is an increase in aggregate supply because output has increased at every price level. 3. Suppose that the aggregate demand and aggregate supply schedules for a hypothetical economy are as shown below: LO3 a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is the equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the equilibrium real output also necessarily the full-employment real output? b. If the price level in this economy is 150, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? If the price level is 250, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? c. Suppose that buyers desire to purchase $200 billion of extra real output at each price level. Sketch in the new aggregate demand curve as AD1. What is the new equilibrium price level and level of real output? 29-8

9 Answer: (a) See the graph. Equilibrium price level = 200; equilibrium real output = $300 billion. No. (b) Exceed by $200 billion; fall short by $200 billion. (c) On the original graph, AD curve shifts rightward. The new equilibrium price level = 250. The new equilibrium GDP = $400 billion. Feedback: (a) See the graph. Equilibrium price level = 200, which occurs where aggregate supply equals aggregate demand, Thus the equilibrium real output = $300 billion. No, the full-capacity level of GDP cannot be determined without more information. (b) At a price level of 150, real GDP supplied is a maximum of $200 billion, less than the real GDP demanded of $400 billion. Thus, quantity demanded exceeds the quantity supplied by $200 billion. At a price level of 250, real GDP supplied is $400 billion, which is more than the real GDP demanded of $200 billion. Thus, quantity demanded falls short of the quantity supplied by $200 billion. 29-9

10 (c) See the graph from part a. Increases in consumer, investment, government, or net export spending might shift the AD curve rightward. The new values for the aggregate demand schedule are: Amount of Real GDP Demanded, Billions Price Level (Price Index) Amount of Real GDP Supplied, Billions $300 (=$100 + $200) 300 $450 $400 (=$200 + $200) $500 (=$300 + $200) $600 (=$400 + $200) $700 (=$500 + $200) The new equilibrium price level = 250 where aggregate supply equals aggregate demand. The new equilibrium GDP = $400 billion. 4. Suppose that the table below shows an economy s relationship between real output and the inputs needed to produce that output: LO3 a. What is productivity in this economy? b. What is the per-unit cost of production if the price of each input unit is $2? c. Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What is the new per-unit cost of production? In what direction would the $1 increase in input price push the economy s aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? d. Suppose that the increase in input price does not occur but, instead, that productivity increases by 100 percent. What would be the new per-unit cost of production? What effect would this change in per-unit production cost have on the economy s aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? Answer: (a) ; (b) $0.75; (c) $1.125; shift left; output will decrease and prices will rise in the short-run; (d) $0.375; shift to right; prices will fall and output will increase in the short run. Feedback: Consider the following example

11 Part a: What is productivity in this economy? Productivity is defined by how much output each unit of the input produces. Productivity = Real GDP / Input Quantity You can use any of the three combinations above. Productivity = $400 / 150 = Part b: What is the per-unit cost of production if the price of each input unit is $2? The per unit cost is defined by how much each unit of output costs to produce. The total cost of production equals $300 (you can use any combination above) when real GDP is $400. Per unit cost = (price of input unit x input quantity) / real GDP For the values above, per unit cost = ($2 x 150) / $400 =$300 / $400 = $0.75 Part c: Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What is the new per-unit cost of production? In what direction would the $1 increase in input price push the economy s aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? The new per unit cost = ($3 x 150) / $400 =$450 / $400 = $ This would cause firms to raise prices at every level of output (higher input cost), thus the aggregate supply schedule would shift left. This would cause output to decrease and prices to rise in short-run

12 Part d: Suppose that the increase in input price does not occur but, instead, that productivity increases by 100 percent. What would be the new per-unit cost of production? What effect would this change in per-unit production cost have on the economy s aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? If productivity increases by 100%, this implies output will double at every input quantity. Real GDP will now be $800 at the input quantity of 150. New productivity = 2 x (original productivity) = From this we can find the required level of real GDP. Productivity = Real GDP / Input Quantity or = Real GDP / 150 Thus, real GDP = $800 = 150 x (rounding). Once we have the new level of real GDP we can find the per unit cost. Per unit cost = (price of input unit x input quantity) / real GDP Per unit cost = ($2 x 150) / $800 = $0.375 This reduction in per unit cost will increase the supply of goods at every price level, thus the aggregate supply schedule will shift to the right. This will cause prices to fall and output to increase in the short run. 5. Refer to the data in the table that accompanies Problem 2. Suppose that the present equilibrium price level and level of real GDP are 100 and $225, and that data set B represents the relevant aggregate supply schedule for the economy. LO4 a. What must be the current amount of real output demanded at the 100 price level? b. If the amount of output demanded declined by $25 at the 100 price shown levels in B, what would be the new equilibrium real GDP? In business cycle terminology, what would economists call this change in real GDP? Answers: $225; $200; a recession. Feedback: Consider the following example. Suppose that the present equilibrium price level and level of real GDP are 100 and $225, and that data set B represents the relevant aggregate supply schedule for the economy

13 Part a: What must be the current amount of real output demanded at the 100 price level? Given that the economy is equilibrium aggregate supply equals aggregate demand. Thus, the real output demanded must also equal $225 (quantity supplied given above). Part b: If the amount of output demanded declined by $25 at the 100 price shown levels in B, what would be the new equilibrium real GDP? In business cycle terminology, what would economists call this change in real GDP? If output demanded fell by $25, the new level of demand is $200. Since the price level does not change the quantity supplied would also fall by $25. The new equilibrium level of real GDP is $200. This decline in output is likely a recession

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