Answers to Exercises

1. The aggregate demand curve differs from the demand curve for an individual good because the aggregate demand curve is the demand curve for total output. In other words the slope of the aggregate demand curve does not depend on the substitution effect. Also, the demand for total output is a function of the general price level instead of an individual product's price.

2. The aggregate demand curve slopes down because of three effects. First, when the price level increases, people's real wealth declines. This wealth effect leads to a reduction in the aggregate demand for output. Second, when the price level increases, the real value of the money supply decreases. This leads to an increase in interest rates, which results in a reduction in the aggregate demand for output. Third, when the price level increases relative to foreign prices, net exports fall, which results in a smaller level of aggregate demand for output.

3 The foreign demand for U.S. produced goods and services increases when foreign income increases. This leads to an increase in aggregate expenditures and aggregate demand (see figure).

4. If foreign prices fall, the demand for foreign produced goods and services will increase. Domestic exports will decrease because of higher relative domestic prices. As a result, aggregate expenditures and aggregate demand fall.

5. The aggregate supply curve differs from the supply curve for an individual good because the former relates the quantity supplied of aggregate output, rather than individual good output, to the general price level rather than to an individual price.

6. a. When the technology of an economy improves, the aggregate supply curve shifts rightward. When resource prices increase, the aggregate supply curve shifts to the left because profits are smaller at each price level. When expected prices are higher, and labor negotiates a higher wage today, the aggregate supply curve will shift to the left.

b.

The aggregate supply curve shifts rightward (from AS1 to AS2) when resource prices fall or technology improves, and shifts leftward (from AS1 to AS3) when price expectations increase and wages rise as a result.

7a. In the short-run, resource costs are fixed so that a higher price level causes profits to rise and induces firms to expand production. The closer we get to capacity output, the less output rises given a price level rise so the curve gets steeper as more and more firms reach their maximum short-term output.

b.

The LRAS is drawn at the potential level of real GDP, Yp, which exists when the natural rate of unemployment is reached. If the unemployment rate falls below the natural rate, then output will rise beyond Yp, so SRAS can lie to the right of LRAS.

8. a.

When aggregate demand falls, the economy moves along the aggregate supply curve to a new equilibrium: P2 and Y2.

b. In the short run, an equilibrium below potential Y can exist, but when people correct their price expectations, the short-run aggregate supply curve shifts rightward to restore equilibrium at potential Y.

9. a.

When U.S. gross domestic product falls, the net exports of Japan also fall, thereby leading to a leftward shift in the aggregate demand curve.

b.

When prices in Korea fall, Japanese goods become relatively more expensive. This leads to a reduction in Japanese net exports and a leftward shift in the aggregate demand curve.

c.

If labor receives a large wage increase, the aggregate supply curve will shift to the left.

d.

If economists predict higher prices next year, price expectations cause resource prices to rise now. This leads to a leftward shift in the aggregate supply curve. Expected higher prices also cause current expenditures to increase, resulting in the aggregate demand curve shifting to the right.

10. The economy is producing at the potential level of real GDP when its productive capacity is operating at its most efficient level -- less than 100 percent capacity. In the short-run, the economy could be producing at a level of capacity utilization greater than this efficient point.

11. a. Equilibrium real GDP rises; the new price level is indeterminate.

b. Equilibrium price level rises; the new level of real GDP is indeterminate.

c. Equilibrium real GDP falls; the new price level is indeterminate.

d. Equilibrium price level falls; the level of real GDP is indeterminate.

12. AD must decrease relative to AS:

13. A horizontal AS has the price level fixed:

14. With a vertical AS curve, real GDP is unchanged:

15. a. Consumption spending falls so AD falls:

b. Net exports rise so AD rises:

c. Net exports fall so AD falls:

d. Government spending increases so AD rises:

e. Higher wages shift AS to left:

f. Technological advance shifts AS to the right:

Answers to Study Guide Homework

1. Wealth effect, interest rate effect, international trade effect

2. Consumption, investment, government spending, net exports

3. Resource prices, technology, expectations

Horizontal: unemployed resources allow firms to expand production without paying more for resources

Rising: as more and more sectors of the economy approach capacity, firms must pay higher prices to attract additional resources

Vertical: no more output can be produced, even at higher prices

5. a. i. Price level increases; real GDP increases

ii. Price level remains the same; real GDP decreases

iii. Price level increases; real GDP increases

iv. Price level remains the same; real GDP decreases

b. i. Price level increases; real GDP remains the same

ii. Price level decreases; real GDP decreases

iii. Price level increases; real GDP remains the same

iv. Price level decreases; real GDP decreases

Answers to Internet Exercise

This exercise allows students to access historical information of U.S. business cycle fluctuations. It further requires students to explore the impact of shifts of the Aggregate Demand and Aggregate Supply Curves on the economy.

Longest contraction: October 1873 through March 1879; shortest contraction: January 1980 through July 1980

Longest expansion: February 1961 through December 1969; shortest expansion: March 1919 through January 1920

November 1982 through July 1990

Data on periods of expansion or contraction in output are not sufficient to identify whether the periods are dominated by AD shifts or AS shifts. We would need to know additional information such as why the AD and AS curves were shifting, such as changes in buying levels or production levels. Additional information on inflation would be helpful. It is necessary to consider the shapes of the curves as well as what causes them to shift.