Chapter 12 When a fall in the value of the dollar against

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Solution

1. A fall in the value of the dollar against other currencies makes U.S. final goods and

services cheaper to foreigners even though the U.S. aggregate price level stays the

1. You are right. When a fall in the value of the dollar against other currencies makes

U.S. final goods and services cheaper to foreigners, this represents a shift of the aggre-

2. Your study partner is confused by the upward – sloping short-run aggregate supply

curve and the vertical long – run aggregate supply curve. How would you explain this?

2. The short- run aggregate supply curve slopes upward because nominal wages are sticky

in the short run. Nominal wages are fixed by either formal contracts or informal

agreements in the short run. So, as the aggregate price level falls and nominal wages

remain the same, production costs will not fall by the same proportion as the aggre-

gate price level. This will reduce profit per unit of output, leading producers to reduce

3. Suppose that in Wageland all workers sign annual wage contracts each year on

January 1. No matter what happens to prices of final goods and services during the

Aggregate Demand and Aggregate

Supply 12

CHAPTER

Solution

3. a. In the short run, the prices of final goods and services in Wageland fall unexpect-

edly but nominal wages don’t change; they are fixed in the short run by the annual

contract. So firms earn a lower profit per unit and reduce output. In the accompa-

nying diagram, Wageland moves along SRAS1 from point A on January 1 to point B

after the fall in prices.

Aggregate

price

LRAS

b. When firms and workers renegotiate their wages, nominal wages will decrease,

shifting the short- run aggregate supply curve in the accompanying diagram right-

ward from SRAS1 to a curve such as SRAS2.

Aggregate

price

level

LRAS

SRAS1

SRAS2

4. The economy is at point A in the accompanying diagram. Suppose that the aggregate

price level rises from P1 to P2. How will aggregate supply adjust in the short run and

in the long run to the increase in the aggregate price level? Illustrate with a diagram.

Aggregate

price

level

LRAS

SRAS1

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Solution

4. In the short run, as the aggregate price level rises from P1 to P2, nominal wages will

not change. So profit per unit will rise, leading to an increase in production from Y1

to Y2. The economy will move from point A to point B in the accompanying diagram.

5. Suppose that all households hold all their wealth in assets that automatically rise

in value when the aggregate price level rises (an example of this is what is called an

5. If all households hold all their wealth in assets that automatically rise in value when

the aggregate price level rises, this will eliminate the wealth effect of a change in

6. Suppose that the economy is currently at potential output. Also suppose that you are

an economic policy maker and that a college economics student asks you to rank, if

possible, your most preferred to least preferred type of shock: positive demand shock,

negative demand shock, positive supply shock, negative supply shock. How would you

rank them and why?

Solution

6. The most preferred shock would be a positive supply shock. The economy would have

higher aggregate output without the danger of inflation. The government would not

need to respond with a change in policy. The least preferred shock would be a nega-

tive supply shock. The economy would experience stagflation. There would be lower

7. Explain whether the following government policies affect the aggregate demand curve

or the short – run aggregate supply curve and how.

a. The government reduces the minimum nominal wage.

7. a. If the government reduces the minimum nominal wage, it is similar to a fall in

nominal wages. Aggregate supply will increase, and the short- run aggregate supply

curve will shift to the right.

b. If the government increases TANF, consumer spending will increase because dis-

8. In Wageland, all workers sign an annual wage contract each year on January 1. In late

8. As labor productivity increases, producers will experience a reduction in production

costs and profit per unit of output will increase. Producers will respond by increasing

the quantity of aggregate output supplied at any given aggregate price level. The short-

run aggregate supply curve will shift to the right. Beginning at short- run equilibrium,

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Solution

SRAS1

SRAS2

Aggregate

price

level

9. The Conference Board publishes the Consumer Confidence Index (CCI) every month

based on a survey of 5,000 representative U.S. households. It is used by many economists to

track the state of the economy. A press release by the Board on June 28, 2011, stated: “The

Conference Board Consumer Confidence Index, which had declined in May, decreased

again in June. The Index now stands at 58.5 (1985 = 100), down from 61.7 in May.”

a. As an economist, is this news encouraging for economic growth?

9. a. No. Consumers base their spending on how confident they are about the income

they will have in the future. Likewise, firms base their investment spending on

what they expect conditions to be like in the future. If consumers become more

optimistic, spending will rise, but if consumers become more pessimistic, spending

will fall. A fall in the CCI indicated that consumers were more pessimistic in June

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Solution

10. There were two major shocks to the U.S. economy in 2007, leading to the severe reces-

sion of 2007–2009. One shock was related to oil prices; the other was the slump in

the housing market. This question analyzes the effect of these two shocks on GDP

using the AD–AS framework.

a. Draw typical aggregate demand and short-run aggregate supply curves. Label the

horizontal axis “Real GDP” and the vertical axis “Aggregate price level.” Label the

equilibrium point E1, the equilibrium quantity Y1, and equilibrium price P1.

b. Data taken from the Department of Energy indicate that the average price of crude

10. a.

SRAS1

Aggregate

price

level

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Solution

SRAS1

SRAS2

Aggregate

price

level

c. The fall in home prices would cause a demand shock because of the wealth effect.

The aggregate demand (AD) curve shifts leftward, from AD1 to AD2. The new

aggregate price level, P3 , could either be equal to, above, or below P1. The new level

of real GDP, Y3, is below the original level, Y1.

SRAS2

SRAS1

Aggregate

price

level

11. Using aggregate demand, short – run aggregate supply, and long – run aggregate supply

curves, explain the process by which each of the following economic events will move

the economy from one long – run macroeconomic equilibrium to another. Illustrate

with diagrams. In each case, what are the short – run and long – run effects on the

aggregate price level and aggregate output?

11. a. A decrease in households’ wealth will reduce consumer spending. Beginning at

long – run macroeconomic equilibrium, E1 in the accompanying diagram, the aggre-

gate demand curve will shift from AD1 to AD2. In the short run, nominal wages

are sticky, and the economy will be in short- run macroeconomic equilibrium at

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Aggregate

price

level

LRAS

SRAS1

SRAS2

b. An increase in disposable income will increase consumer spending; at any given

aggregate price level, the aggregate demand curve will shift to the right. Beginning

at long – run macroeconomic equilibrium, E1 in the accompanying diagram, the

aggregate demand curve will shift from AD1 to AD2. In the short run, nominal

wages are sticky, and the economy will be in short-run macroeconomic equilibrium

at point E2. The aggregate price level is higher than at E1, and aggregate output will

be higher than potential output. The economy faces an inflationary gap. As wage

12. Using aggregate demand, short – run aggregate supply, and long – run aggregate sup-

ply curves, explain the process by which each of the following government policies

will move the economy from one long – run macroeconomic equilibrium to another.

Illustrate with diagrams. In each case, what are the short – run and long – run effects on

the aggregate price level and aggregate output?

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Solution

12. a. An increase in taxes will decrease consumer spending by households. Beginning at

E1 in the accompanying diagram, the aggregate demand curve will shift leftward

from AD1 to AD2. In the short run, nominal wages are sticky, and the economy will

be in short- run macroeconomic equilibrium at point E2. The aggregate price level is

b. An increase in the quantity of money will encourage people to lend, lowering inter-

est rates and increasing investment and consumer spending; at any given aggregate

price level, the quantity of aggregate output demanded will be higher. Beginning at

long – run macroeconomic equilibrium, E1 in the accompanying diagram, the aggre-

gate demand curve will shift from AD1 to AD2. In the short run, nominal wages are

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c. An increase in government spending will increase aggregate demand; at any given

aggregate price level, the quantity of aggregate output demanded will be higher.

Beginning at long – run macroeconomic equilibrium, E1 in the accompanying dia-

gram, the aggregate demand curve will shift from AD1 to AD2. In the short run,

nominal wages are sticky, and the economy will be in short- run macroeconomic

Aggregate

price

level

LRAS

SRAS1

SRAS2

13. The economy is in short – run macroeconomic equilibrium at point E1 in the accompa-

nying diagram. Based on the diagram, answer the following questions.

Aggregate

price

level

LRAS

SRAS1

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Solution

13. a. The economy is facing a recessionary gap because Y1 is less than the potential out-

put of the economy, YP.

b. The government could use either fiscal policy (increases in government spending or

reductions in taxes) or monetary policy (increases in the quantity of money in cir-

c. If the government did not intervene to close the recessionary gap, the economy

would eventually self- correct and move back to potential output on its own. Due

to unemployment, nominal wages will fall in the long run. The short- run aggregate

supply curve will shift to the right, and eventually it will shift from SRAS1 to SRAS2

in the accompanying diagram. The economy will be back at potential output but at

a lower aggregate price level.

Aggregate

price

level

LRAS

SRAS1

SRAS2

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Solution

14. In the accompanying diagram, the economy is in long – run macroeconomic equilibri-

um at point E1 when an oil shock shifts the short – run aggregate supply curve to SRAS2.

Based on the diagram, answer the following questions.

Aggregate

price

level

LRAS

SRAS2

14. a. As a result of the increase in the price of oil and the shift to the left of the short-

run aggregate supply curve, real GDP decreases to Y2 (and with it unemployment

rises) and the aggregate price level increases to P2 as shown in the accompanying

diagram. This combined problem of inflation and unemployment is known as

stagflation.

Aggregate

price

level

LRAS

SRAS1

SRAS2

b. The government can use fiscal and monetary policies to either increase real GDP or

lower the aggregate price level, but not both. If the government increases govern-

ment spending, decreases taxes, or increases the quantity of money in circulation,

it can raise real GDP but it will also raise the aggregate price level. This is illustrated

in the diagram accompanying part a by the rightward shift of AD1 to AD2.

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Solution

Aggregate

price

level

LRAS

SRAS1

SRAS2

15. The late 1990s in the United States were characterized by substantial economic growth

with low inflation; that is, real GDP increased with little, if any, increase in the aggre-

gate price level. Explain this experience using aggregate demand and aggregate supply

curves. Illustrate with a diagram.

15. Increases in both long -run and short-run aggregate supply, along with increases in

aggregate demand, can explain how real GDP grew with little if any increase in the

aggregate price level. The accompanying diagram shows how the economy could move

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Solution

16. In each of the following cases, in the short run, determine whether the events cause a

shift of a curve or a movement along a curve. Determine which curve is involved and

the direction of the change.

16. a. As the value of the dollar in terms of other currencies increases and American

producers pay less in dollar terms for foreign steel, producers’ profit per unit

increases and they are willing to supply a greater quantity of aggregate output at

any given aggregate price level. The short- run aggregate supply curve will shift to

the right.

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