Chapter 18 – Extending the Analysis of Aggregate Supply
18-1
CHAPTER 18
Extending the Analysis of Aggregate Supply
A. Short-Answer, Essays, and Problems
1. What is the basic difference between the short run and long run as these terms relate to macroeconomics?
Why does this difference occur?
2. Describe the characteristics of the short-run aggregate supply curve. Explain what happens to: (1) nominal
wages; (2) employment; (3) output; (4) revenues; and, (5) profits as the price level increases from the full–
employment level of output. Then explain what happens to these variables as the price level decreases
from the full-employment-level of output.
3. Suppose the potential level of real domestic output (Q) for a hypothetical economy is $250 and the price
level (P) initially is 100. Use the following short-run aggregate supply schedules below to answer the
questions.
AS (P = 100)
AS (P = 110)
AS (P = 90)
P
Q
P
P
Q
110
280
110
110
310
100
250
100
100
280
90
220
90
90
250
(a) What will be the short-run level of real GDP if the price level rises unexpectedly from 100 to 110
because of an increase in aggregate demand? Falls unexpectedly from 100 to 90 because of a decrease
in aggregate demand? Explain each situation.
(b) What will be the long-run level of real GDP when the price level rises from 100 to 110? Falls from
100 to 90? Explain each situation.
(c) Show the circumstances described in (a) and (b) on the graph below and derive the long-run aggregate
supply curve.
4. Suppose the potential level of real domestic output (Q) for a hypothetical economy is $160 and the price
level (P) initially is 200. Use the following short-run aggregate supply schedules to answer the questions.
AS (P = 200)
AS (P = 210)
AS (P = 190)
P
Q
P
P
Q
210
190
210
210
220
200
160
200
200
190
190
130
190
190
160
(a) What will be the short-run level of real GDP if the price level rises unexpectedly from 200 to 210
because of an increase in aggregate demand? Falls unexpectedly from 200 to 190 because of a
decrease in aggregate demand? Explain each situation.
(b) What will be the long-run level of real GDP when the price level rises from 200 to 210? Falls from
200 to 190? Explain each situation.
Chapter 18 – Extending the Analysis of Aggregate Supply
18-2
5. Explain the reasoning behind why the long-run aggregate supply curve is vertical.
6. Describe the characteristics of the long-run aggregate supply curve. Explain how changes in the price level
affect the short-run aggregate supply curve and the long-run aggregate supply curve.
7. What is the long-run equilibrium in the extended aggregate demand and aggregate supply model?
8. Describe the process that occurs with demand-pull inflation in the extended aggregate demand and
aggregate supply model.
9. Describe cost-push inflation in the extended aggregate demand and aggregate supply model. Explain the
policy dilemma for government policy if they take no action or use monetary and fiscal policy to counter
the cost-push inflation.
10. Differentiate between “demand–pull” and “cost–push” inflation in the basic aggregate demand and
aggregate supply model.
11. Explain what happens in the extended aggregate demand and aggregate supply model when there is a
recession.
12. Using the extended AD–AS model, explain how inflation depends on aggregate demand and not the level
of real GDP.
13. How do modern economies experience ongoing inflation when achieving economic growth?
14. How would economic growth be shown in a production possibilities graph and in a graph of long-run
aggregate supply?
15. How would economic growth and mild inflation be depicted in the extended aggregate demand and
aggregate supply model?
16. What are three significant generalizations supported by results from the extended AD-AS model?
17. What is the Phillips Curve? What concept does it illustrate?
18. Explain the Phillips Curve concept and construct an example of the curve on the below graph.
19. If the Phillips Curve exists in reality, what dilemma does this create for fiscal and monetary policies?
Explain.
20. What is stagflation and what was one of its causes in the 1970s and early 1980s?
Chapter 18 – Extending the Analysis of Aggregate Supply
18-3
21. Assume the following information is relevant for an advanced economy over a three-year period. Describe
in detail the macroeconomic situation faced by this society. Is cost-push inflation evident? What
corrective policies would you recommend and why?
Year
Price
index
Increase in
labor
productivity
Increase in
industrial
production
Unemp.
Rate
Average
hourly
wage
1
167
4%
4%
4.5%
$6.00
2
174
3
2
5.2
6.50
3
181
2.5
1.5
5.8
7.10
22. What contributed to stagflation’s demise between 1982 and 1989? How did these events affect aggregate
supply and the Phillips Curve?
23. What economic events and policies led to the emergence of the U.S. economy from the stagflation of the
late 1970s and early 1980s? Depict the effect of these events using the extended AD–AS model.
24. What is the misery index? Why do economists find it to be a flawed measure?
25. Compare and contrast the short-run Phillips Curve and the long-run Phillips Curve.
26. Answer the questions based on the following diagram.
(a) Assume the economy is initially at point B1 and there is an increase in aggregate demand which results
in a 4% increase in prices. Describe the short–run and long-run outcomes that would result in this
economy.
(b) Assume the economy is initially at point B2, and there is an increase in aggregate demand. What will
happen in the economy? Explain, using the graph.
(c)Based on this diagram, what would the prediction be for the natural (full–employment) rate of
unemployment?
27. Why is the difference between the actual and expected rates of inflation important for explaining inflation?
28. What is disinflation? Give examples of it.
29. Why is the difference between the actual and expected rates of inflation important for explaining
disinflation?
31. “Lower prices are always good for business.” Evaluate this statement.
31. How do supply-side economists see reducing taxes as a way to improve productivity?
32. Explain the basic arguments for supply-side economics.
33. Contrast “supply–side” economics with “demand–side” fiscal policy.
Chapter 18 – Extending the Analysis of Aggregate Supply
18-4
34. What is the Laffer Curve? Explain the relationship that is shown in the curve.
35. Use the following diagram to answer the next three questions.
(a) What is this diagram called and what does it say about the relationship between tax rates and tax
revenues?
(b) If tax rates are at level c, should the government raise or lower tax rates to increase revenues? Explain.
(c) What does tax level b represent? Could policy makers find the actual rate that b represents? Discuss
this point.
36. Draw a Laffer Curve and explain the relationship it purports to portray. Why might this curve be important
for macroeconomic policy?
37. (Consider This) How did Arthur Laffer use Robin Hood and Sherwood Forest to explain the advantage of
supply-side economics?
38. What is supply-side economics? What is the rationale for it? Is it effective?
39. What are the major criticisms of the Laffer Curve and supply-side economics?
40. How do supply-side advocates respond to critics? How valid is their defense?
41. (Last Word) Do tax increases reduce real GDP?
Chapter 18 – Extending the Analysis of Aggregate Supply
18-5
B. Answers to Short-Answer, Essays, and Problems
1. What is the basic difference between the short run and long run as these terms relate to macroeconomics?
Why does this difference occur?
2. Describe the characteristics of the short-run aggregate supply curve. Explain what happens to: (1) nominal
wages; (2) employment; (3) output; (4) revenues; and, (5) profits as the price level increases from the full–
employment level of output. Then explain what happens to these variables as the price level decreases
from the full-employment-level of output.
3. Suppose the potential level of real domestic output (Q) for a hypothetical economy is $250 and the price
level (P) initially is 100. Use the following short-run aggregate supply schedules below to answer the
questions.
AS (P = 100)
AS (P = 110)
AS (P = 90)
P
Q
P
P
Q
110
280
110
110
310
100
250
100
100
280
90
220
90
90
250
(a) What will be the short-run level of real GDP if the price level rises unexpectedly from 100 to 110
because of an increase in aggregate demand? Falls unexpectedly from 100 to 90 because of a decrease
in aggregate demand? Explain each situation.
(b) What will be the long-run level of real GDP when the price level rises from 100 to 110? Falls from
100 to 90? Explain each situation.
(c) Show the circumstances described in (a) and (b) on the graph below and derive the long-run aggregate
supply curve.
Chapter 18 – Extending the Analysis of Aggregate Supply
4. Suppose the potential level of real domestic output (Q) for a hypothetical economy is $160 and the price
level (P) initially is 200. Use the following short-run aggregate supply schedules to answer the questions.
AS (P = 200)
AS (P = 210)
AS (P = 190)
P
Q
P
P
Q
210
190
210
210
220
200
160
200
200
190
190
130
190
190
160
(a) What will be the short-run level of real GDP if the price level rises unexpectedly from 200 to 210
because of an increase in aggregate demand? Falls unexpectedly from 200 to 190 because of a
decrease in aggregate demand? Explain each situation.
(b) What will be the long-run level of real GDP when the price level rises from 200 to 210? Falls from
200 to 190? Explain each situation.
5. Explain the reasoning behind why the long-run aggregate supply curve is vertical.
6. Describe the characteristics of the long-run aggregate supply curve. Explain how changes in the price level
affect the short-run aggregate supply curve and the long-run aggregate supply curve.
Chapter 18 – Extending the Analysis of Aggregate Supply
18-7
7. What is the long-run equilibrium in the extended aggregate demand and aggregate supply model?
8. Describe the process that occurs with demand-pull inflation in the extended aggregate demand and
aggregate supply model.
9. Describe cost-push inflation in the extended aggregate demand and aggregate supply model. Explain the
policy dilemma for government policy if they take no action or use monetary and fiscal policy to counter
the cost-push inflation.
Chapter 18 – Extending the Analysis of Aggregate Supply
10. Differentiate between “demand–pull” and “cost–push” inflation in the basic aggregate demand and
aggregate supply model.
11. Explain what happens in the extended aggregate demand and aggregate supply model when there is a
recession.
12. Using the extended AD–AS model, explain how inflation depends on aggregate demand and not the level
of real GDP.
13. How do modern economies experience ongoing inflation when achieving economic growth?
14. How would economic growth be shown in a production possibilities graph and in a graph of long-run
aggregate supply?
15. How would economic growth and mild inflation be depicted in the extended aggregate demand and
aggregate supply model?
Chapter 18 – Extending the Analysis of Aggregate Supply
16. What are three significant generalizations supported by results from the extended AD-AS model?
17. What is the Phillips Curve? What concept does it illustrate?
18. Explain the Phillips Curve concept and construct an example of the curve on the below graph.
19. If the Phillips Curve exists in reality, what dilemma does this create for fiscal and monetary policies?
Explain.
20. What is stagflation and what was one of its causes in the 1970s and early 1980s?
Chapter 18 – Extending the Analysis of Aggregate Supply
21. Assume the following information is relevant for an advanced economy over a three-year period. Describe
in detail the macroeconomic situation faced by this society. Is cost-push inflation evident? What
corrective policies would you recommend and why?
22. What contributed to stagflation’s demise between 1982 and 1989? How did these events affect aggregate
supply and the Phillips Curve?
23. What economic events and policies led to the emergence of the U.S. economy from the stagflation of the
late 1970s and early 1980s? Depict the effect of these events using the extended AD–AS model.
24. What is the misery index? Why do economists find it to be a flawed measure?
Chapter 18 – Extending the Analysis of Aggregate Supply
25. Compare and contrast the short-run Phillips Curve and the long-run Phillips Curve.
26. Answer the questions based on the following diagram.
(a) Assume the economy is initially at point B1 and there is an increase in aggregate demand which results
in a 4% increase in prices. Describe the short–run and long-run outcomes that would result in this
economy.
(b) Assume the economy is initially at point B2, and there is an increase in aggregate demand. What will
happen in the economy? Explain, using the graph.
(c) Based on this diagram, what would the prediction be for the natural (full-employment) rate of
unemployment?
27. Why is the difference between the actual and expected rates of inflation important for explaining inflation?
Chapter 18 – Extending the Analysis of Aggregate Supply
28. What is disinflation? Give examples of it.
29. Why is the difference between the actual and expected rates of inflation important for explaining
disinflation?
30. “Lower prices are always good for business.” Evaluate this statement.
31. How do supply-side economists see reducing taxes as a way to improve productivity?
32. Explain the basic arguments for supply-side economics.
33. Contrast “supply–side” economics with “demand–side” fiscal policy.
Chapter 18 – Extending the Analysis of Aggregate Supply
18–13
34. What is the Laffer Curve? Explain the relationship that is shown in the curve.
35. Use the following diagram to answer the next three questions.
(a) What is this diagram called and what does it say about the relationship between tax rates and tax
revenues?
(b) If tax rates are at level c, should the government raise or lower tax rates to increase revenues? Explain.
(c) What does tax level b represent? Could policy makers find the actual rate that b represents? Discuss
this point.
Chapter 18 – Extending the Analysis of Aggregate Supply
36. Draw a Laffer Curve and explain the relationship it purports to portray. Why might this curve be important
for macroeconomic policy?
37. (Consider This) How did Arthur Laffer use Robin Hood and Sherwood Forest to explain the advantage of
supply-side economics?
38. What is supply-side economics? What is the rationale for it? Is it effective?
Chapter 18 – Extending the Analysis of Aggregate Supply
39. What are the major criticisms of the Laffer Curve and supply-side economics?
40. How do supply-side advocates respond to critics? How valid is their defense?
41. (Last Word) Do tax increases reduce real GDP?