Macro Practice Questions, Chapter-End Questions CHAPTER 30

Graphically, demand-pull inflation is shown as a:

rightward shift of the AD curve along an upsloping AS curve.

If aggregate demand decreases, and as a result, real output and employment decline but the price level remains unchanged, it is most likely that:

the price level is inflexible downward and a recession has occurred.

When aggregate demand declines, the price level may remain constant, at least for a time, because:

firms individually may fear that their price cut may set off a price war.

If personal taxes were decreased and resource productivity increased simultaneously, the equilibrium:

output would necessarily rise.

When aggregate demand declines, many firms may reduce employment rather than wages because wage reductions may:

reduce worker morale and work effort, and thus lower productivity.

If investment increases by $10 billion and the economy's MPC is .8, the aggregate demand curve will shift:

rightward by $50 billion at each price level

Graphically, the full-employment, low-inflation, rapid-growth economy of the last half of the 1990s is depicted by a:

rightward shift of the aggregate demand curve and a rightward shift of the aggregate supply curve.

The aggregate supply curve

shows the various amounts of real output that businesses will produce at each price level

Which of the following is incorrect?

When the price level increases, real balances increase and businesses and households find themselves wealthier and therefore increase their spending.

The short-run aggregate supply curve represents circumstances where:

input prices are fixed, but output prices are flexible

Other things equal, appreciation of the dollar:

decreases aggregate demand in the United States and may increase aggregate supply by reducing the prices of imported resources.

Which of the following would most likely reduce aggregate demand (shift the AD curve to the left)?

An appreciation of the U.S. dollar.

8. 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. LO6

Answer: Both events would be represented by a leftward shift in aggregate demand, and the initial declines in spending would be multiplied. (See Figure 30.2, shift from AD1 to AD3.) 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.

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

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 aggregate supply curve relatively flat to the left of the full-employment output and relatively steep to the right? LO3

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. Which of the following will shift the aggregate supply curve to the right? LO4 a. A new networking technology increases productivity all over the economy. b. The price of oil rises substantially. c. Business taxes fall. d. The government passes a law doubling all manufacturing wages.

Answer: The two answers for which aggregate supply would actually shift right are: a. A new networking technology increases productivity all over the economy; c. Business taxes fall.  Feedback: The scenario that a new networking technology increases productivity all over the economy will cause the aggregate supply curve to shift right because the higher levels of productivity will enable firms to produce more output (and generate more revenues) from any given set of inputs. With inputs fixed and revenues increasing due to selling more output, profits will rise. And higher profits will encourage firms to produce more at any given price level. Consequently, the aggregate supply curve will shift right. Under the scenario that business taxes fall, aggregate supply will shift to the right because firms' after-tax profits will increase no matter what the price level is. Those higher profits will encourage businesses to produce more, and hence the aggregate supply curve will shift to the right. The other two answers are incorrect because they both describe scenarios that would cause the aggregate supply curve to shift to the left (rather than to the right). For instance, a scenario in which the price of oil rises substantially is one in which many firms will find their costs increasing substantially. That will reduce their profits and hence their desire to produce output. The result will be less output supplied no matter what the price level happens to be, which is the same thing as saying that the aggregate supply curve will shift left. A scenario in which the government passes a law doubling all manufacturing wages is also one in which the aggregate supply curve will shift to the left. The higher wages will reduce firm profits and hence the desire of firms to produce output. That will result in the aggregate supply curve shifting left because less output will be produced no matter what the price level is.

3. Label each of the following descriptions as being either an immediate-short-run aggregate supply curve, a short-run aggregate supply curve, or a long-run aggregate supply curve. LO3 a. A vertical line. b. The price level is fixed. c. Output prices are flexible, but input prices are fixed. d. A horizontal line. e. An upsloping curve. f. Output is fixed.

Answer: a. Long-run; b. Immediate-short-run; c. Short-run; d. Immediate-short-run; e. Short-run; f. Long-run Feedback: A vertical line implies a long-run aggregate supply curve because only long-run aggregate supply curves are vertical (due to the economy always returning to the full-employment output level in the long run). The price level is fixed implies an immediate-short-run supply curve because only immediate-short-run supply curves are horizontal (due to prices being completely inflexible in the immediate short run). Output prices are flexible but input prices are fixed implies a short-run aggregate supply curve because it is only during the short run that input prices are fixed while output prices are flexible. By contrast, in the immediate short run, both input and output prices are fixed, and in the long run, both input and output prices are flexible. A horizontal line implies an immediate-short-run aggregate supply curve because only immediate-short-run aggregate supply curves are horizontal (due to prices being fixed in the immediate short run). An upsloping curve implies a short-run aggregate supply curve because only short-run aggregate supply curves are upsloping (due to the fact that in the short run input prices are fixed while output prices are flexible, so that if output prices rise, profits go up and encourage firms to produce more, hence the upward slope and the positive relationship between the price level and output). Output is fixed implies a long-run aggregate supply curve because only long-run aggregate supply curves have fixed output (due to the fact that in the long run, output will always return to the full-employment level of real GDP no matter what the price level is).

(Last Word) In response to the Great Recession, the federal government engaged in significant deficit-funded spending, but it did not fully achieve the desired result. Which of the following best explains why the fiscal policy actions fell short of their objective?

Consumers did not respond to the fiscal stimulus as well as hoped, as they put more income into saving and repaying debt.

The aggregate demand curve is:

downsloping because of the interest-rate, real-balances, and foreign purchases effects.

The determinants of aggregate supply:

include resource prices and resource productivity.

A decrease in aggregate demand will cause a greater decline in real output the:

less flexible is the economy's price level.