Download Problem Sheet 1

İstanbul Bilgi University
Spring Term 2008
Introduction to Economics (EC 152)
Department of Economics
Answer Key of Problem Sheet 10
Aggregate Demand and Aggregate Supply
1)
How does the economy’s behavior in the short run differ from its behavior in the long run?
Draw the model of aggregate demand and aggregate supply. What variables are on the two
axes?
The economy’s behavior in the short run differs from its behavior in the long run because
the assumption of monetary neutrality applies to the long run, not the short run.
In the short run, real and nominal variables are highly intertwined.
Figure 1 shows the model of aggregate demand and aggregate supply. The
horizontal axis shows the quantity of output and the vertical axis shows the price
level.
Figure 1
2)
Explain the three reasons why the aggregate-demand curve slopes downward. Give an
example of an event that would shift the aggregate demand curve? Which way would this
event shift the curve?
The aggregate-demand curve slopes downward for three reasons. First, when prices
fall, the value of dollars in people’s wallets and bank accounts rises, so they are
wealthier. As a result, they spend more, so aggregate demand increases. Second,
when prices fall, people need less money to make their purchases, so they lend more
out, which reduces the interest rate. The lower interest rate encourages businesses to
invest more, raising aggregate demand. Third, since lower prices lead to a lower
interest rate, investors move money from domestic investment to foreign investment,
supplying dollars to the foreign-exchange market, thus causing the dollar to
depreciate. The decline in the real exchange rate causes net exports to increase,
which raises aggregate demand.
Any event that alters the level of consumption, investment, government purchases, or net
exports at any price level will lead to a shift in aggregate demand. An increase in
expenditure will shift the aggregate demand curve to the right, while a decline in
expenditure will shift the aggregate demand curve to the left.
3)
Explain why the long-run aggregate supply curve is vertical. Explain three theories for why
the short-run aggregate supply curve is upward sloping?
The long-run aggregate-supply curve is vertical because the price level does not affect
the long-run determinants of real GDP, which include supplies of labor, capital,
natural resources, and the level of available technology. This is just an application of
the classical dichotomy and monetary neutrality.
There are three reasons why the short-run aggregate-supply curve slopes upward.
First, the sticky-wage theory suggests that because nominal wages are slow to adjust,
a decline in the price level means real wages are higher, so firms hire fewer workers
and produce less, causing aggregate supply to decline. Second, the sticky-price
theory suggests that the prices of some goods and services are slow to change. Then,
if some economic event causes the overall price level to decline, prices that are sticky
won’t be able to adjust immediately, so relative prices of those goods will rise and the
demand for those goods will decline, leading firms to cut back on production. Thus,
lower overall prices lead to lower aggregate supply. Third, the misperceptions theory
suggests that changes in the overall price level can temporarily mislead suppliers.
When the price level falls below the level that was expected, suppliers think that the
relative prices of their products have declined, so they produce less. Thus, a lower
price level reduces aggregate supply.
4)
The following-events have their initial impact on which of the following: aggregate demand,
long-run aggregate supply or short-run aggregate supply? Does the curve shift to the right or
left?
a. The government repairs aging roads and bridges.
AD, right
b. OPEC raises oil prices
AS,left
c. Turkish citizens feel more secure in their jobs and become more optimistic.
AD,right
d.
e.
f.
g.
h.
5)
Intel invents a new and more powerful computer chip.
Productivity rises LRAS,
right
The government increases the minimum wage
the natural rate of unemployment
rises
LRAS, left
Wage demands of new college graduates fall
SRAS, right
The central bank decreases the money supply
AD,left
A severe hurricane damages factories along the east coast.
Smaller capital stock
LRAS, left
For the following four cases, trace the impact of each shock in the aggregate supply and
aggregate demand model by answering the following three questions for each: What happens
to prices and output in the short run? What happens to prices and output in the long run if the
economy is allowed to adjust to long-run equilibrium on its own? If policymakers had
intervened to move back to the natural rate instead of allowing the economy to self-correct, in
which direction should they have moved aggregate demand?
a.
Aggregate demand shifts right
Prices rise, output rises. Prices rise, output returns to
the natural rate. Shift AD to the left
b.
Short-run aggregate supply shifts left
Prices rise, output falls. Pricelevel returns to
original value, output returns to the natural rate. Shift AD to the right.
6.
Suppose that a decrease in the demand for goods and services pushes the economy into recession.
What happens to the price level? If the government does nothing, what ensures that the economy still
eventually gets back to the natural rate of output?
ANSWER: A decrease in aggregate demand causes the price level to fall. If the government does not
respond, then the actual price level will be below the price level that people expected. Individuals
will gradually correct their misperception of the price level, so expected prices will fall, causing the
aggregate supply curve to shift to the right. The rightward shift in aggregate supply eventually
restores the economy to the natural rate of output.