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Solution
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
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
Solution
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,
S-166 CHAPTER 12 AGGREGATE DEMAND AND AGGREGATE SUPPLY
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
CHAPTER 12 AGGREGATE DEMAND AND AGGREGATE SUPPLY S-167
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.
E1
SRAS1
Aggregate
price
level
S-168 CHAPTER 12 AGGREGATE DEMAND AND AGGREGATE SUPPLY
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
P3
LRAS
SRAS1
E3
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
E1
P1
S-172 CHAPTER 12 AGGREGATE DEMAND AND AGGREGATE SUPPLY
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
P3
P2
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.
S-176 CHAPTER 12 AGGREGATE DEMAND AND AGGREGATE SUPPLY
