Macro Chapter 20

1. 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 AD and AS, what happens to prices and output in the short run.

- Prices rise; output falls

1. 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

Aggregate- supply curve

A curve that shows 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 in long-run equilibrium. Then, suppose workers and firms suddenly expect higher prices in the future and agree to an increase in wages.) e. If policymakers were able to move output back to the natural level of output, what would the policy do to prices?

- Prices would rise more and then remain there

1. 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

1. Stagflation occurs when the economy experiences

- Rising prices and falling output

(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.) d. If policymakers wanted to move output back to the natural level of output, what should they do?

- Shift aggregate demand to the right

(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 event in the model of aggregate demand and aggregate supply by explaining which curve shifts which way.

- Short- run aggregate supply shifts left

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

- A drop in oil prices

1. 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

( 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

- Aggregate demand shifts to the right

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

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

- An increase in price expectations

(Suppose the economy is at a point such as point B in the image below. That is, aggregate demand has decreased, and the economy is in a recession. Describe the adjustment process necessary for the economy to adjust on its own to point C for each of the 3 theoretical short run aggregate supply curves.) a. 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.

(Suppose the economy is at a point such as point B in the image below. That is, aggregate demand has decreased, and the economy is in a recession. Describe the adjustment process necessary for the economy to adjust on its own to point C for each of the 3 theoretical short run aggregate supply curves.) b. 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.

(Suppose the economy is at a point such as point B in the image below. That is, aggregate demand has decreased, and the economy is in a recession. Describe the adjustment process necessary for the economy to adjust on its own to point C for each of the 3 theoretical short run aggregate supply curves.) c. 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.

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 policy makers choose to adjust aggregate demand to eliminate the recession rather than let the economy adjust or self correct?

- 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

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

The government increases the minimum wage.

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

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

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

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 expectation that may be associated with wage demands and oil prices only shift short-run aggregate supply.

Name the 3 key facts about economic fluctuations.

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

If the federal reserve increases the money supply, the aggregate-demand cure shifts to the left

- False: AD shifts to the right

An increase in the price expectations shift the long-run aggregate-supply curve to the left

- False: Changes in price expectations shift the short-run aggregate-supply curve

If the economy is in a recession, the economy will adjust to a 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

The misperceptions theory explains why the long-run AS curve is downward sloping

- False: It explains why the short-run AS curve is upward sloping

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

- False: It has grown at 3% a year

If policymakers chose 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

Economists refer to fluctuations in output as the business cycle because movements in output are regular and predictable.

- False: fluctuations in output are irregular

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

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

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

- Is vertical because an equal change in all prices and wages leaves output unaffected.

1. According to the wealth effect, aggregate- demand slopes downward negatively because

- Lower prices increase the value of money holdings and consumer spending increases.

1. 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.

1. Suppose the price level falls but suppliers only notice that the price of their 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...

- Misperceptions theory of the short-run aggregate-supply curve

(Suppose the economy is at a point such as point B in the image below. That is, aggregate demand has decreased, and the economy is in a recession. Describe the adjustment process necessary for the economy to adjust on its own to point C for each of the 3 theoretical short run aggregate supply curves.) d. Do you think the type of adjustments would take place more quickly form a recession or form a period when output was above the long run natural level, why?

- More slowly from a recession because it requires prices to be reduced, and prices are usually stickier 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?

- 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 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.) g. Is it likely than an increase in price expectations and wages alone can cause a permanent increase in the price level? Why?

- No. Increases in the cost of production need to be accommodated by government policy to permanently raise prices

(Suppose the economy is in long- run equilibrium. Then suppose the Federal reserve suddenly increases the money supply) d. Does an increase in the money supply move output above the natural level indefinitely? Why?

- No. Over time, people and firms adjust to the new higher amount of spending by raising their prices and wages.

1. Suppose the economy is initially in long-run equilibrium. Them 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 in long- run equilibrium. Then suppose the Federal reserve suddenly increases the money supply) b. What happens to the price level and real output in the short run?

- Price level rises, and real output rises

(Suppose the economy is in long- run equilibrium. Then suppose the Federal reserve suddenly increases the money supply) c. If the economy can 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 economist attach to the long-run impact of a change in the money supply on the economy?

- Price level rises; and real output stays the same. Money neutrality

Short- run aggregate supply shifts left

- Price rise; output falls. Price level returns to original value; output returns to the natural level. Shift aggregate demand to the right.

1. 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

a. Aggregate demand shifts left

- Prices fall; output falls. Prices fall; output returns to the natural level. Shift aggregate demand to the right

1. Suppose the economy is initially in long-run equilibrium. Then suppose there is a reduction in military spending. 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

a. Short- run aggregate supply shifts right

- Prices fall; output rises. Price level returns to original value; output returns to the natural level. 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.) b. What happens to the price level and real output in the short run?

- Prices rise and output falls

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

OPEC raises oil prices

- Short-run aggregate supply, shift left

a. A drought destroys much of the Midwest corn crop.

- Short-run aggregate supply, shift left

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

- Short-run aggregate supply, shift right

1. 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

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

- The classical dichotomy and monetary neutrality effects

(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.) f. If policymakers had done nothing at all, what would have happened to the wage rate as the economy self- corrected or adjusted back to the natural level of output on its own?

- 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.

A rise in price expectations that causes wages to rise causes the short-run AS curve to shift left

- True

A rise in the price of oil tends to cause stagflation

- True

In 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

One reason aggregate demand slope downward in 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

What are 3 reasons the aggregate-demand curve slopes downward? Explain

- 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 rates, the dollar depreciates, and net exports increase.

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

- When the economy is at the natural rate of unemployment

Does a shift in aggregate demand alter output in the short run? Why?

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

Menu Costs

Costs associated with changing prices

Model of aggregate demand and supply

Most economists use to explain short-run fluctuation in the economy around its long- run trend

Aggregate demand shifts right

Prices rise; output rises. Prices rise; output returns to the natural level. Shift aggregate- demand to the left.

The business cycle

Short-run economic fluctuations

(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.) c. What name do we have for this combination of movements in output and prices?

Stagflation

Natural level of output:

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

Investment in a particularly volatile component of spending across the business cycle.

True