Chapter 15 ~ Aggregate Demand and Aggregate Supply

In the model of aggregate demand and aggregate supply, the initial impact of an increase in consumer optimism is to

shift-aggregate demand to the right

The government raises unemployment benefits, which raises the natural rate of unemployment

both short-run and long aggregate supply, shift left

The government increases the minimum wage

both short-run and long-run aggregate supply, shift left

A technological advance takes place in the application of computers to the manufacturing of steel

both short-run and long-run aggregate supply, shift right

Stagflation occurs when the economy experiences

rising prices and falling output

Suppose the price level falls. Because of fixed nominal wage contracts, firms become less profitable, and they cut back on production. This is a demonstration of the

sticky-wage theory of the short-run aggregate-supply curve

Aggregate-Supply Curve

A curve that shows the quantity of goods and services that firms are willing to produce at each price level

Aggregate-Demand Curve

A curve that shows the quantity of goods and services that households, firms, the government, and customers abroad are willing to buy at each price level

Stagflation

A period of falling output and rising prices

Recession

A period of mildly falling incomes and rising unemployment

Depression

A period of unusually severe falling incomes and rising unemployment

Accommodative Policy

A policy of increasing aggregate demand in response to a decrease in short-run aggregate supply

Suppose the economy is initially in long-run equilibrium. Then suppose there is a drought that destroys much of the wheat crop. If policymakers allow the economy to adjust to long-run equilibrium on its own, according to the model of aggregate demand and aggregate supply, what happens to prices and output in the long run?

output and the price level are unchanged from their initial values

Suppose the economy is operating in a recession such as point B in Exhibit 4. If policymakers allow the economy to adjust to the long-run natural level on its own,

people will reduce their expectations, and the short-run aggregate supply will shift right

Because price expectations are reduced, wage demands of new college graduates fall

short-run aggregate supply, shift right

The natural level of output is the amount of real GDP produced

when the economy is at the natural rate of unemployment

The Business Cycle

Short-run economic fluctuations

Suppose the economy is in long-run equilibrium. Then, suppose the Federal Reserve suddenly increases the money supply. (a) Describe the initial impact of this event in the model of aggregate demand and aggregate supply by explaining which curve shifts which way. (b) What happens to the price level and real output in the short run? (c) If the economy is allowed to adjust to the increase in the money supply, what happens to the price level and real output in the long run when compared to their original levels? What name do economists attach to the long-run impact of a change in the money supply on the economy? (d) Does an increase in the money supply move output above the natural level indefinitely? Why or why not?

(a) aggregate demand shifts to the right (b) price level rises, and real output rises (c) price level rises, and real output stays the same. Money neutrality (d) no. over time, people and firms adjust to the new higher amount of spending by raising their prices and wages

(a)What happens to prices and output in the short run? (b)What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own? (c)If policymakers had intervened to move output back to the natural level instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand? aggregate demand shifts left

(a) prices fall, output falls (b) prices fall, output returns to the natural level (c) shift aggregate demand to the right

(a)What happens to prices and output in the short run? (b)What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own? (c)If policymakers had intervened to move output back to the natural level instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand? short-run aggregate supply shifts right

(a) prices fall, output rises (b) price level returns to original value, output returns to the natural level (c) shift aggregate demand to the left

(a)What happens to prices and output in the short run? (b)What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own? (c)If policymakers had intervened to move output back to the natural level instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand? short-run aggregate supply shifts left

(a) prices rise, output falls (b) price level returns to original value, output returns to the natural level (c) shift aggregate demand to the right

(a)What happens to prices and output in the short run? (b)What happens to prices and output in the long run if the economy is allowed to adjust to long-run equilibrium on its own? (c)If policymakers had intervened to move output back to the natural level instead of allowing the economy to self-correct, in which direction should they have moved aggregate demand? aggregate demand shifts right

(a) prices rise, output rises (b) prices rise, output returns to the natural level (c) shift aggregate demand to the left

Suppose the economy is in long-run equilibrium. Then, suppose workers and firms suddenly expect higher prices in the future and agree to an increase in wages. (a) Describe the initial impact of this even in the model of aggregate demand and aggregate supply by explaining which curve shifts which way. (b) What happens to the price level and real output in the short run? (c) What name do we have for this combination of movements in output and prices? (d) If policymakers wanted to move output back to the natural level of output, what should they do? (e) If policymakers were able to move output back to the natural level of output, what would the policy do to prices? (f) If policymakers had done nothing at all, what would have happened to the wage rates as the economy self-corrected or adjusted back to the natural level of output on its own? (g) Is it likely than an increase in price expectations and wages alone can cause a permanent increase in the price level? Why or why not?

(a) short-run aggregate supply shifts left (b) prices rise, and output falls (c) stagflation (d) shift aggregate demand to the right (e) prices would rise more and remain there (f) the high unemployment at the low level of output would put pressure on the wage to fall back to its original value shifting short-run aggregate supply back to its original position (g) no. increases in the cost of production need to be "accommodated" by government policy to permanently raise prices

Why is a decrease in the money supply unlikely to be neutral in the short run?

Because a decrease in aggregate demand from a decrease in the money supply may reduce the price level unexpectedly. In the short run, some prices and wages are stuck, and some producers have misperceptions regarding relative prices causing output to fall

If the economy is in a recession, why might policymakers choose to adjust aggregate demand to eliminate the recession rather than let the economy adjust, or self-correct, on its own?

Because they think they can get the economy back to the long-run natural level of output more quickly or, in the case of a negative supply shock, because they are more concerned with output than inflation

What causes both short-run and long-run aggregate supply to shift together? What causes only the short-run aggregate supply to shift while the long-run aggregate supply remains stationary?

Changes in the available factors (labor, capital, natural resources) and technology shift both long-run and short-run aggregate supply. Changes in price expectations that may be associated with wage demands and oil prices only shift short-run aggregate supply

Menu Costs

Costs associated with changing prices

Name the three key facts about economic fluctuations

Economic fluctuations are irregular and unpredictable, most macroeconomic quantities fluctuate together, and when output falls, unemployment rises

Explain the slope of the short-run aggregate-supply curve using the sticky-wage theory.

In the short run, nominal wages are fixed based on fixed-price expectations. If actual prices unexpectedly fall while nominal wages remain fixed, firms are less profitable, and they cut back on production

Which component of aggregate demand is most volatile over the business cycle?

Investment

(aggregate demand has decreased and economy is in a recession) Do you think the type of adjustments described above would take place more quickly from a recession or from a period when output was above the long-run natural level? Why or why not?

More slowly from a recession because it requires prices to be reduced, and prices are usually more sticky downward. The adjustment when output is above normal requires prices and wages to rise

Does a shift in aggregate demand alter output in the long run? Why or why not?

No. In the long run, output is determined by factor supplies and technology (long-run aggregate supply). Changes in aggregate demand only affect prices in the long run

Suppose OPEC breaks apart and oil prices fall substantially. Initially, which curve shifts in the aggregate-supply and aggregate-demand model? In what direction does it shift? What happens to the price level and real output?

Short-run aggregate supply shifts right. Prices fall, and output rises

Model of Aggregate Supply and Demand

The model most economists use to explain short-run fluctuations in the economy around its long-run trend

Natural Rate of Output

The production of goods and services that an economy achieves in the long run when unemployment is at its natural or normal rate

What are the three reasons the aggregate-demand curve slopes downward? Explain them

Wealth effect: lower prices increase the value of money holdings and consumer spending increases. Interest-rate effect: lower prices reduce the quantity of money held, some is loaned, interest rates fall, and investment spending increases. Exchange-rate effect: lower prices decrease interest rates, the dollar depreciates, and net exports increase.

Does a shift in aggregate demand alter output in the short run? Why or why not?

Yes. Changes in aggregate demand cause actual prices to deviate from expected prices. Due to sticky wages, sticky prices, and misperceptions about relative prices, firms respond by changing output

Which of the following events shifts the short-run aggregate-supply curve to the right?

a drop in oil prices

Which of the following statements about economic fluctuations is true?

a variety of spending, income, and output measures can be used to measure economic fluctuations because most macroeconomic quantities tend to fluctuate together

The Federal Reserve decreases the money supply

aggregate demand, shift left

Americans feel more secure in their jobs and become more optimistic

aggregate demand, shift right

The government repairs aging roads and bridges

aggregate demand, shift right

Which of the following would not cause a shift in the long-run aggregate-supply curve?

an increase in price expectations

(aggregate demand has decreased and economy is in a recession) the sticky-wage theory

at point B, prices have fallen, but nominal wages are stuck at a high level based on a higher price expectation. Firms are less profitable, and they cut back on production. As workers and firms recognize the fall in the price level (learn to expect P3), new contracts will have a lower nominal wage. The reduction in labor costs causes firms to increase production at each price level shifting the short-run aggregate supply to the right

(aggregate demand has decreased and economy is in a recession) the sticky-price theory

at point B, some firms have not reduced their prices because of menu costs. Their products are relatively more expensive, and sales fall. When they realize the lower price level is permanent (learn to expect P3), they lower their prices and output rises at each price level, shifting the short-run aggregate supply to the right.

(aggregate demand has decreased and economy is in a recession) the misperceptions theory

at point B, some firms mistakenly believe that only the price of their product has fallen and they have cut back on production. As they realize that all prices are falling (learn to expect P3), they will increase production at each price, which will shift short-run aggregate supply to the right

A drought destroys much of the Midwest corn crop

short-run aggregate supply, shift left

if the federal reserve increases the money supply, the aggregate-demand curve shifts to the left

false, aggregate demand shifts to the right

an increase in price expectations shifts the long-run aggregate-supply curve to the left

false, changes in price expectations shift the short-run aggregate-supply curve

economists refer to fluctuations in output as the "business cycle" because movements in output are regular and predictable

false, fluctuations in output are irregular

if the economy is in a recession, the economy will adjust to long-run equilibrium on its own as wages and price expectations rise

false, in a recession, the economy adjusts to long-run equilibrium as wages and prices fall

in the long run, an increase in government spending tends to increase output and prices

false, in the long run, it tends to increase prices, but it has no impact on output

the misperceptions theory explains why the long-run aggregate-supply curve is downward sloping

false, it explains why the short-run aggregate-supply curve is upward sloping

if policymakers choose to try to move the economy out of a recession, they should use their policy tools to decrease aggregate demand

false, policymakers should increase aggregate demand

over the last 50 years, U.S. real GDP has grown at about 5% per year

false, the U.S. economy has grown at about 3% per year

OPEC raises oil prices

short-run aggregate supply, shift left

Which of the following statements is true regarding the long-run aggregate-supply curve? The long-run aggregate-supply curve

is vertical because an equal change in all prices and wages leaves output unaffected

According to the wealth effect, aggregate demand slopes downward (negatively) because

lower prices increase the value of money holdings and consumer spending increases

According to the interest-rate effect, aggregate demand slopes downward (negatively) because

lower prices reduce money holdings, increase lending, interest rates fall, and investment spending increases

Suppose the price level falls but suppliers only notice that the price of their particular product has fallen. Thinking there has been a fall in the relative price of their product, they cut back on production. This is a demonstration of the

misperceptions theory of the short-run aggregate-supply curve

Suppose the economy is initially in long-run equilibrium. Then suppose there is a reduction in military spending due to the end of the Cold War. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the short run?

prices fall, output falls

Suppose the economy is initially in long-run equilibrium. Then suppose there is a reduction in military spending due to the end of the Cold War. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the long run?

prices fall, output is unchanged from its initial value

Suppose the economy is initially in long-run equilibrium. Then suppose there is a drought that destroys much of the wheat crop. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the short run?

prices rise, output falls

According to the model of aggregate supply and aggregate demand, in the long run, an increase in the money supply should cause

prices to rise and output to remain unchanged

Policymakers are said to "accommodate" an adverse supply shock if they

respond to the adverse supply shock by increasing aggregate demand, which further raises prices

Suppose the economy is operating in a recession such as point B in Exhibit 4. If policymakers wished to move output to its long-run natural level, they should attempt to

shift aggregate demand to the right

Which of the following is not a reason why the aggregate-demand curve slopes downward?

the classical dichotomy/monetary neutrality effects

a rise in price expectations that causes wages to rise causes the short-run aggregate-supply curve to shift left

true

a rise in the price of oil tends to cause stagflation

true

if the classical dichotomy and monetary neutrality hold in the long run, then the long-run aggregate-supply curve should be vertical

true

in the short run, if the government cuts back spending to balance its budget, it will likely cause a recession

true

investment is a particularly volatile component of spending across the business cycle

true

one reason aggregate demand slopes downward is the wealth effect: a decrease in the price level increases the value of money holdings and consumer spending rises

true

the short-run effect of an increase in aggregate demand is an increase in output and an increase in the price level

true