978-1259663048 Chapter 26 Solutions Manual

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CHAPTER 26: THE SHORT-RUN KEYNESIAN POLICY

MODEL: DEMAND-SIDE POLICIES

Questions and Exercises

1. According to Keynesians the economy could deviate from its potential because if

aggregate demand falls for some unexplained reason, firms would respond by

2. When prices are falling, profits decline, making entrepreneurs hesitant to start

businesses, slowing the growth of the economy. Asset values (prices of assets

3. The paradox of thrift is the notion that an increase in saving can lead to a decrease

4. One expects the AD curve to be vertical because when the price level rises, all

prices rise together. That is, since wages have risen as much as prices for

5. a. A rise in the price level reduces the value of cash people hold. They withdraw

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b. Assuming fixed exchange rates, a rise in the price level would make goods less

c. When there is a rise in the price level the holders of money become poorer so they

6. Five factors that shift the AD curve are: (1) changes in foreign income, (2)

changes in expectations, (3) changes in exchange rates, (4) changes in the

7. A falling price level could reduce aggregate demand (shift the demand curve to

8. a. The AD curve will be steeper because a change in the price level will be offset by

b. The AD curve will become steeper if a fall in the price level doesn’t make people

c. The AD curve will be steeper if a fall in the price level creates expectations of a

d. Assuming that poor people spend a higher percentage of their income than rich

9. Two factors that shift the SAS curve are changes in productivity and changes in

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10. a. The SAS curve will shift up, with inflation equal to 1 percent since wages rise by

11. The LAS curve is vertical because potential output depends on the capacity for

12. a. An increase in the availability of inputs will shift the LAS curve to the right. The

13. If the economy is in short-run equilibrium below potential output, underutilization

of inputs will cause input prices to fall, causing the short-run aggregate supply

14. a. This implies that productivity is increasing significantly. If computers are a large

15. a It is likely that the rise in oil prices will shift the SAS curve up and the drop in

world income will shift the AD curve in, causing equilibrium income to fall even

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b. We might suggest expansionary fiscal

and monetary policy to shift the AD

curve out (from AD0 to AD2) and

16. a. The slowing of foreign economies

will reduce exports, shifting the AD

b. An economy operating above potential output is shown by point A in graph (b).

To keep the inflation from rising (the SAS curve from shifting up), the government

c. A new technology that increases potential output will shift the LAS curve to the

right (from LAS0 to LAS1), as shown in graph (c), creating excess capacity and

Real output

AD1AD0

SAS

LAS

Real output

AD0

AD1

SAS0

SAS1

(a) (c)

Real output

AD1AD0

SAS

LAS

(b)

LAS1

LAS0

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AD0

AD1

SAS1

LAS

17. When the price level falls, people may

expect aggregate demand to decline

because falling asset prices reduce

18. To design an appropriate fiscal policy, it is important to know the level of

19. The simple model abstracts from a number of important issues such as the

20. Countercyclical fiscal policy is difficult to implement because it is difficult to

Questions from Alternative Perspectives

1. Austrian

a. It could be consistent with the AS/AD model if one sees the SAS and AD curves

b. Austrians would favor an institutional system that had far less government

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SAS0

2. Institutionalist

a. When oil production declines, the production possibility curve shifts in, the LAS

b. This will shift real income from individuals and nations that are net consumers of

3. Post Keynesian

While Minsky predicted many of the current problems, he did not predict the timing

of those problems, which allows people to argue that his theory is not generally

4. Radical

a. The excess capacity is shown by

the gap between the quantity of

b. What should be done is a

judgment question and

judgments differ. Classicals tend

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c. It suggests that the model (positive economics) embodies in it certain biases

d. While some measure of value judgment is inherent in positive economics, it

Issues to Ponder

1. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was

b. It fits in nicely with the “other things constant” assumption since the policy

c. It definitely was primarily in the art of economics since the above method is the

2. Yes, they would emphasize the inherent value of the program rather than

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