Download Chapters 21-25

Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
69
Chapter 21 Economic Fluctuations
Review Questions
2.
While the labor demand curve can shift, it is unlikely to shift rapidly enough to explain booms
and recessions. The demand for labor is determined largely by how productive labor is, and this is
slow to change. Similarly, the labor supply curve—which arises from the preferences of millions
of families about working in the market—is unlikely to shift suddenly enough to explain
recessions. Further, in recessions, an unusually large number of people are looking for work. But
this observation is not consistent with a leftward shift in the labor supply curve, which would
mean that fewer people want to work.
4.
A quick glance at Table 1 in the chapter shows that this statement is false. While some economic
fluctuations are caused by changes in military spending, others have been caused by changes in
business investment, new home construction, and spending on cars and other energy-related
products.
Problems and Exercises
2.
In the classical model, a decrease in investment spending could not cause a recession because any
decrease in investment spending will lead to the decrease of demand for loanable funds, which in
turn will lead to lower interest rates. As interest rates fall, the incentive for savings decreases, so
households save less, and, necessarily, spend more, offsetting perfectly the decrease in investment
spending.
Economic Applications Exercises
2.
The circular flow of a market economy shows that households receive income from selling
resources (land, labor, and capital) to firms. GDP can be measured by adding up all of the
payments to households for land, labor, and capital. Thus when real GDP increases, personal
income will also increase, as shown in the first figure, and when real GDP decreases, so too will
personal income. The recession in 2001 and lingering economic weakness in 2002 had associated
with it a slowdown in the rate of growth in personal income. Since that time, personal income has
generally increased although at a modest level. Real GDP growth rates seem to be picking up
steam, led by real estate activity and increased defense spending.
Chapter 22 The Short-Run Macro Model
Review Questions
2. The marginal propensity to consume is (1) the slope of the consumption function; (2) the change
in consumption divided by the change in disposable income; or (3) the amount by which
consumption spending rises when disposable income rises by one dollar.
4.
The two components of planned investment or investment spending are business purchases of
plant and equipment and new home construction. Actual investment includes these two categories
as well as changes in business inventories.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
70
6.
8.
If government spending increases, then firms that sell goods and services to the government
will earn additional revenue, which will end up going to the factors of production that produced
those goods, increasing household income. The increase in income leads households to increase
spending, increasing the revenue of firms that produce consumption goods. Income increases
once again, leading to a further increase in spending, and so on. In the end, GDP will rise by a
multiple of the increase in government spending.
An automatic stabilizer is a force that interferes with, and reduces the size of, the multiplier
effect. Some automatic stabilizers for the U.S. economy include taxes, transfer payments, interest
rates, prices, imports, and consumer behavior.
10. No. In the classical long-run model, fiscal policy is completely ineffective due to the
crowding out effect. In the short-run macro model, however, an increase in government
purchases causes a multiplied increase in equilibrium GDP.
Problems and Exercises
2.
a.
Real GDP
Autonomous
Consumption
MPC x Disposable
Income
Consumption =
Autonomous
Consumption + (MPC
x Disposable Income)
$0
$100
$200
$300
$400
$500
$600
$30
$30
$30
$30
$30
$30
$30
$0
$85
$170
$255
$340
$425
$510
$30
$115
$200
$285
$370
$455
$540
b.
Real GDP
Consumption
Spending
Planned
Investment
Government
Spending
Net Exports
Aggregate
Expenditures
$0
$100
$200
$300
$400
$500
$600
$30
$115
$200
$285
$370
$455
$540
$40
$40
$40
$40
$40
$40
$40
$20
$20
$20
$20
$20
$20
$20
-$15
-$15
-$15
-$15
-$15
-$15
-$15
$75
$160
$245
$330
$415
$500
$585
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
71
c.
d. $500 billion is the equilibrium level of real GDP.
e. If the actual level of real GDP in this economy is $200 billion, then the economy will expand.
This is because aggregate expenditures ($245 billion) are greater than real GDP ($200
billion), so firms find their inventories falling, and will expand output, leading to a higher real
GDP in the future.
f. If planned investment falls to $25 billion, the equilibrium level of real GDP will fall from
$500 billion to $400 billion.
4.
a. Inventories will unexpectedly fall; sending firms the signal to produce more output. GDPA is
not sustainable because the extra production will move the economy to the right along the
horizontal axis.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
72
b. Inventories will unexpectedly rise; sending firms the signal to produce less output. GDPB is
not sustainable because cut in production will move the economy to the left along the
horizontal axis.
6.
a.
b.
c.
d.
Real GDP and total employment will increase.
Real GDP and total employment will increase.
Real GDP and total employment will decrease.
Real GDP and total employment will increase.
8.
a. In the table in Problem 2, the second column (C) would be affected; each number in the
column would become smaller, since households would spend less at each level of income.
b. The change in saving is the vertical distance between the aggregate expenditure lines.
c.
Real
Aggregate
Expenditure
(C + I + NX) 1
(C + I + NX) 2
45°
Y2
Y1
Real
GDP
10. a. If the MPC is 0.95, then the expenditure multiplier is 20. Therefore, the change in real GDP is
20 x $7500 = $150,000.
b. If the MPC is 0.65, then the expenditure multiplier is 2.86. Therefore, the change in real GDP
is 2.86 x -$300 thousand = -$858 thousand.
c. If the MPC is 0.75, then the expenditure multiplier is 4. Therefore, the change in real GDP is
4 x -$5 billion = -$20 billion.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
12.
73
a. The change in real GDP = (-0.75/(1 – 0.75)) x $400 thousand = -$1200 thousand.
b. The change in real GDP resulting from the tax cut = (-0.60/(1-0.60)) x -$500 thousand = $750
thousand. The change in real GDP resulting from the cut in government spending = (-1/(1 –
0.60)) x -$500 thousand = -$1250 thousand. The net change in real GDP = $750 thousand + $1250 thousand = -$500 thousand.
Challenge Questions
2.
Y = [a – (b  T) + IP + G + NX] / (1 – b) = [1000 – (0.65 x 700) + 800 + 600 - 200] / (1 – 0.65) =
4,985.71. At this equilibrium, C = a + b(Y – T) = 1000 + 0.65(4985.71 – 700) = 3,785.71.
Therefore, in equilibrium, we have aggregate expenditure = C + IP + G + NX = 3,785.71 + 800 +
600 - 200 = 4,985.71, which is equal to equilibrium real GDP.
4.
No. Whenever government spending and taxes change by the same amount, real GDP changes by
that same amount.
Chapter 23 The Banking System and the Money Supply
Review Questions
2.
M1 includes cash in the hands of the public, demand deposits, other checking account deposits,
and travelers checks. M2 includes cash in the hands of the public, demand deposits, other
checking account deposits, travelers checks, savings-type accounts, retail MMMF balances, and
small denomination time deposits.
4.
Net worth is listed on the liabilities side of a balance sheet because it is, in a sense, what the bank
would owe to its owners if it went out of business.
6.
The important difference between the Board of Governors and the FOMC is that the FOMC has
the important task of establishing U.S. monetary policy, while the Board of Governors supervises
and regulates member banks, supervises the 12 Federal Reserve District Banks, and sets reserve
requirements and approves the discount rate.
8.
When the Fed wants to increase the money supply, it purchases bonds from a bond dealer, and
pays with a Federal Reserve check. When the bond dealer deposits the check in its bank account,
it counts as reserves for the bank. The bank has excess reserves, which it lends out. The reserves
will find their way to another bank, leading to excess reserves at that bank, and so on. Each time a
bank obtains new reserves and lends out the excess, it ends up with more deposits than it started
with. As the process continues, the total quantity of demand deposits—and with it the money
supply—increases.
When the Fed wants to decrease the money supply, it sells bonds to a bond dealer, and makes
the bank pay with reserves. The bank has deficient reserves, so it must decrease its volume of
loans, and decrease the volume of its deposits at the same time. As loans are paid back to this
bank, some other bank in the system will develop deficient reserves, and have to decrease the
volume of its loans and deposits, and so on. As the process continues, the total quantity of
demand deposits—and with it, the money supply—decreases.
10. Governments have more than one measure of the money supply because measuring the money
supply is harder than it might seem. For example, while you can’t use funds in a savings account
to buy things directly, you can easily move those funds into a checking account, so the question
arises as to whether savings account balances are money.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
74
12.
Banks cannot create wealth when they create money. “Creating money” is different from “creating wealth.” When a bank creates money by giving someone a loan, that person has extra money
in his account, but owes the same amount to the bank. The net change in their wealth is $0.
Problems and Exercises
2.
The money supply can increase by a maximum of ((1/0.15) x $50 million = $333.33 million. If
the required reserve ratio is 0.18, the money supply can increase by a maximum of ((1/0.18) x
$50 = $277.78 million.
4.
M1 = cash in hands of public + demand deposits + other checkable deposits + travelers’ checks =
$400 billion + $400 billion + $250 billion + $10 billion = $1,060 billion.
6.
With no excess reserves, each dollar of reserves supports 1/RRR in demand deposits. Initially,
with the required reserve ratio of 0.2, $200 billion in reserves supports $200 billion x (1/0.20) =
$1000 billion in demand deposits. To decrease demand deposits by $50 billion (to $950 billion),
solve this equation for RRR:
$950 = (1/RRR) x $200 billion

RRR = 0.21.
The Fed must increase the required reserve ratio to 0.21.
8. To find the answer, substitute the desired change in the money supply ($500 billion) and the
demand deposit multiplier (10 = 1/0.10) into the equation for the change in the money supply, and
solve for the change in reserves:
$500 billion = 10 x Reserves

Reserves = $500 billion/10 = $50 billion
The Fed will need to increase initial deposits by $50 billion. It can do this by buying government
bonds worth $50 billion from the public.
If the required reserve ratio is 0.15 (so that the demand deposit multiplier = 1/0.15 = 6.67), the
Fed will need to increase initial deposits by $500 billion/(6.67) = $74.96 billion. It can do this by
buying government bonds worth $74.96 billion from the public.
10. a.
First National Bank
Assets
Fed buys bond,
+$1,000 in reserves
Bond seller deposits
the Fed’s check:
Bank makes loan:
–$800 in reserves
+$800 in loans
Total effect:
+$200 in reserves
+$800 in loans
Liabilities
+$1,000 in demand deposits
+$1,000 in demand deposits
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
75
Second United Bank
Assets
Borrower deposits
$800 loan:
Liabilities
+$800 in reserves
Bank makes loan:
–$640 in reserves
+$640 in loans
Total effect:
+$160 in reserves
+$640 in loans
+$800 in demand deposits
+$800 in demand deposits
Third State Bank
Assets
Borrower deposits
$640 loan:
+$640 in reserves
Bank makes loan:
–$512 in reserves
+$512 in loans
Total effect:
+$128 in reserves
+$512 in loans
Liabilities
+$640 in demand deposits
+$640 in demand deposits
b. When the Fed buys the $1,000 bond, and its check is deposited at First National Bank, the
money supply increases by $1,000 (since $1,000 in demand deposits that didn’t exist before
have been created). When First National Bank lends out $800 in reserves, the money supply
increases by another $800. When Second United lends out $640 and Third State lends out
$512, the money supply increases by $640 and $512, respectively.
c. In the end, demand deposits will rise by $1,000  (1/0.2) = $5,000.
12.
a. The Fed will have to reduce the required reserve ratio.
b. The Fed will have to increase the required reserve ratio.
Challenge Questions
2.
a. The effects of the Fed’s purchase of a $100,000 bond, when each depositor holds half of his
money as cash, and the required reserve ratio is 0.1:
76
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
Bank #1
Assets
Liabilities
Fed buys bond,
+$50,000 in reserves
Bond-seller deposits
half of the Fed’s check:
Bank makes loan:
–$45,000 in reserves
+$45,000 in loans
Total effect:
+$5,000 in reserves
+$45,000 in loans
+$50,000 in demand deposits
+$50,000 in demand deposits
Bank #2
Assets
Borrower deposits
half of $45,000 loan:
Liabilities
+$22,500 in reserves
Bank makes loan:
–$20,250 in reserves
+$20,250 in loans
Total effect:
+$2,250 in reserves
+$20,250 in loans
+$22,500 in demand deposits
+$22,500 in demand deposits
Bank #3
Assets
Borrower deposits
half of $20,250 loan:
+$10,125 in reserves
Bank makes loan:
–$9,112.50 in reserves
+$9,112.50 in loans
Total effect:
+$1,012.50 in reserves
+$9,112.50 in loans
Liabilities
+$10,125 in demand deposits
+$10,125 in demand deposits
b. Starting with the original increase in bank #1’s reserves of $50,000, demand deposits increase
by $50,000 + $33,500 + . . . = $50,000 (1 + 0.5 + 0.52 + 0.53 + …) = $50,000 [1/(1 – 0.5)] =
$50,000 [1/0.5] = $50,000 (2) = ΔReserves x 2. The demand deposit multiplier is 2 in this
example. It is smaller than in the case when depositors hold no cash. With an RRR = 0.1, and
no additional cash holding by the public, the demand deposit multiplier was 1/0.1 = 10.
c. The ultimate change in demand deposits will be $50,000  2 = $100,000.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
77
Economic Applications Exercises
2.
a. Answers may vary.
b. This article concludes that risk and uncertainty are two concepts that emanate from
randomness. Although risk is quantifiable, uncertainty is not and it arises from imperfect
knowledge about the way the world behaves. Uncertainty relates to the questions of how to
deal with the unprecedented, and whether the world will behave tomorrow the way it behaved
in the past. For investors, not being able to distinguish between risk and uncertainty is
hazardous to their financial health. Although we have a fairly good understanding of stock
market risk, assessing stock market uncertainty is incomparably harder.
The function of Federal Reserve System as the lender of last resort encourages banks to
take on more risk. Given the stock market risk and uncertainty, absence of regulations
separating commercial from investment banking would exacerbate the moral hazard problem
and lead to more instability
Chapter 24 The Money Market and the Interest Rate
Review Questions
2.
The money demand curve gives the total quantity of money demanded in the economy at each
interest rate. As the interest rate rises, the opportunity cost of holding money increases.
Individuals want to take advantage of the rising interest rate and choose to hold more bonds, and
thus they demand less money. This inverse relationship explains why the curve slopes downward.
A change in the interest rate involves a movement along the money demand curve. In part (a),
there is a rightward movement along the money demand curve, and in part (b), there is a leftward
movement along the curve. As the price level or real income decreases [parts (c) and (f)], money
demand decreases, and the curve shifts leftward. As the price level or real income increases [parts
(d) and (e)], money demand increases, and the curve shifts rightward.
4.
An excess supply of money implies an excess demand for bonds. As the public buys bonds, the
price of bonds increases. An increase in the price of bonds results in a lower interest rate. At a
lower interest rate, people are willing to hold more money. The excess supply of money
disappears, and the market returns to equilibrium.
In the case of an excess demand for money, there is an excess supply of bonds. As people sell
their bonds, the price of bonds falls. Falling bond prices means a higher interest rate. As the
interest rate increases, the opportunity cost of holding money rises, and money demand decreases.
The money market returns to equilibrium.
6.
a. An increase in the interest rate discourages business spending on plant and equipment. If the
firm must borrow funds to invest, then a higher interest rate means that the firm will have to
pay back more to the lender. If instead the firm finances its project out of its own funds, a
higher interest rate implies a higher opportunity cost of using the firm’s funds on plant and
equipment instead of lending them out.
b. New housing purchases are inversely related to interest rates since an increase in the interest
rate raises the total cost of a house for families that need to borrow money to make the
purchase.
c. Since people often borrow money to purchase consumer durables, an increase in the interest
rate raises the monthly payments on these items. Consequently, consumers purchase fewer
durables when interest rates rise.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
78
8. The classical model is a long-run framework. It uses the loanable funds market to explain how the
interest rate is determined. But the classical theory of the interest rate does not take into account
short-run changes in output, such as recessions and booms, and it ignores changes in the public’s
preference for holding its wealth in money versus bonds. Thus, we could not explain the short-run
determination of the interest rate in the classical, loanable funds framework.
Similarly, changes in output and changes in the public’s preference for holding money and
bonds—which are captured in our analysis of the money market—do not last forever. Thus, it
would not be appropriate to explain the long-run determination of the interest rate using the money
market and the short-run macro framework.
10. The federal funds rate is the interest rate that banks with excess reserves charge for lending
reserves to other banks.
Problems and Exercises
2.
a. The money supply increases by $195 million and the money supply curve shifts rightward.
b. The money supply decreases by $119 million and the money supply curve shifts leftward.
4.
a.
Price
Amount Paid in
One Year
Interest Payment
Interest Rate
Quantity of
Money
Demanded
$18,000
$18,500
$19,000
$19,500
$20,000
$20,000
$20,000
$20,000
$20,000
$20,000
$2000
$1500
$1000
$500
$0
11.11%
8.11%
5.26%
2.56%
0%
$2300 billion
$2600 billion
$2900 billion
$3200 billion
$3500 billion
b.
c.
Since, in equilibrium, MS = MD, the money supply equals $2900 billion. The price of the
bond is $19,000.
If the money supply increases to $3200 billion, there will be a shortage of bonds, bond
prices will rise, and the interest rate will fall until money demand once again equals money
supply. This will happen when the interest rate falls to 2.56% and the price of bonds rises to
$19,500.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
79
6.
Interest
Rate
s
M2
s
M1
r'
r2
E
E
r1
d
M
d
M
Y = Y1
Y = Y2
Money
Real
Aggregate
Expenditure
AEr =
r1
AE r =
r2
J
K
45°
Y2
Y1
Real
GDP
Initially, the economy is at point E in the top diagram and point J in the bottom diagram. To raise
interest rates, the Fed conducts an open-market sale of bonds. The money supply de to M2s and
interest rates begin to rise, heading towards r. As interest rates increase, investment and
autonomous consumption spending decrease, and real GDP begins to decrease. As real GDP falls,
M1d shifts to M2d. The economy comes to rest at an interest rate between r1 and r, such as r2, and
the aggregate expenditure line falls. Equilibrium is reached at E and K in the top and bottom
diagrams, respectively. The Fed’s action causes the money supply to decrease, the interest rate to
increase, and GDP to decrease.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
80
8.
The student’s reasoning is incorrect. He is confusing a shift in the money demand curve with a
movement along the money demand curve. An increase in the demand for money will shift the
money demand curve to the right, from Md1 to Md2. At the current interest rate, r1, the quantity of
money demanded increases from Q1 to Q2, creating an excess demand for money. The excess
demand causes the interest rate to rise to r2, leading to a decrease in quantity demanded from Q2
back to Q1.
10. Due to economic uncertainties after September 11, many people wanted to sell their bonds and
shift their wealth to money—a rightward shift in the money demand curve. This would have led
to higher interest rates, which could have triggered a recession by reducing planned investment
spending and autonomous consumption spending. The Fed increased the money supply rapidly to
prevent the rise in interest rates.
Challenge Questions
2. The net export effect makes fiscal policy less potent in changing GDP. To see why, consider
expansionary fiscal policy. In an open economy there will be an initial effect:
G
Multiplier
Real GDP
Effect
and a net export effect:
M
d
Interest
Rate
Dollar
Appreciates
NX
Multiplier
Real GDP
Effect
The net export effect works in the opposite direction of the initial effect and leads to a smaller
overall change in real GDP than if it did not occur.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
81
4.
Initially, assume the economy is in equilibrium at point A. Then the Fed decreases the money
supply from MS1 to MS2. If this were the only change to occur, then the interest rate would rise
from r1 to r2. However, if the demand for money were to simultaneously decrease, by more than
the money supply increased, as seen by the shift from MD1 to MD2, then the interest rate would
fall to r3.
Chapter 25 Aggregate Demand and Aggregate Supply
Review Questions
2.
False. Fiscal policy (which involves changing the level of government purchases and/or taxes)
will shift the AD curve; however, changes in these variables in order to achieve other government
goals, or changes in autonomous consumption spending, investment spending, net exports, or the
money supply will also shift the AD curve.
4.
The short-run aggregate supply curve captures the idea that changes in real GDP cause changes in
the price level. It slopes upward because a rise in GDP increases unit costs, thereby increasing the
price level, and a fall in GDP decreases unit costs, consequently depressing the price level.
6.
The economy’s self-correcting mechanism is the long-run adjustment process whereby the
economy returns to full employment after a demand shock. When a demand shock pushes the
economy away from full-employment, changes in the wage rate and the price level return the
economy to full-employment. For instance, consider a negative demand shock that decreases
GDP. Assuming that initially the economy operated at full-employment GDP, a decrease in GDP
will cause wages to fall due to high unemployment. As wages fall, unit costs decrease and the
price level decreases causing GDP to rise. When the economy returns to full-employment output,
this process stops.
8.
Since the long-run aggregate supply curve is vertical, fiscal policy has no effect on GDP in the
long run. It can only affect the price level. This is consistent with the classical view of fiscal
policy. The vertical long-run AS curve also supports the classical view of crowding out.
Beginning at full-employment output, a rise in government purchases will have no effect on GDP.
Therefore, private sector spending must fall by as much as government purchases increase. That
is, complete crowding out occurs, just as the classical model predicts.
10.
Real GDP growth did not keep up with productivity in 2002 for two reasons. First, real GDP
growth was unusually low because business investment had fallen (perhaps due to continuing
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
82
global uncertainty after September 11, 2001, and because, due to high levels of investment during
the 1990s, firms had caught up with the amount of capital they desired). Second, productivity
growth did not slow down because firms were able to adjust their workforce more easily to
fluctuations in production due to a greater reliance on part-time and temporary workers.
Problems and Exercises
2.
Initially, the economy is at points E, J, and S. When the money supply curve shifts from MS1 to
MS2 the interest rate rises. The higher interest rate causes aggregate expenditure to decrease,
leading to a decrease in GDP. At any price level, equilibrium GDP has decreased, and thus the
AD curve shifts to the left. If the price level remains unchanged, the economy will come to rest at
points F, K, and T. The interest rate is higher, real aggregate expenditure is lower, and the AD
curve has shifted to the left.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
83
4.
Assume that the economy is initially in equilibrium at point E. A decline in investment spending
will shift the AD curve leftward, leading to a lower price level and smaller GDP at the new
equilibrium point F. If the price level were held constant, then GDP would fall even more, to
point G.
6.
The increase in autonomous consumption shifts the AD curve rightward from AD1 to AD2,
increasing both the price level and real GDP in the short run (from point A to point B). In the
absence of government intervention, eventually the AS curve would shift leftward from AS 1 to
AS2, moving the economy to point C. In the long run, an increase in autonomous consumption
would lead to a higher price level and no net change in real GDP.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
84
8.
a.
If the Fed did nothing, eventually the AS curve would have shifted back to its original
position as unusually high unemployment would drive the wage rate down, and the economy
would have returned to point E.
b.
The Fed’s actions were designed to boost investment spending, which would shift the AD
curve rightward to ADpost 1991. If successful, the economy would reach a new equilibrium at
point F.
c. If the Fed did nothing then the price level would have fallen as the AS curve shifted
downward. As it was, the price level rose due to the Fed action.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
10.
85
a.
An increase in competition will shift the AS curve downward, from AS1 to AS2.
b.
After the initial increase in competition shifts the AS curve downward from AS 1 to AS2, the
Fed will cut interest rates in order to shift the AD curve rightward, from AD 1 to AD2. The
economy will reach a new equilibrium at point F, where the price level is once again P1. Real
GDP increases from Y1 to Y2.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
86
12. a.
A temporary decrease in nonlabor input prices will temporarily move the economy from point
(A) to point (B), as the AS curve temporarily shifts from AS1 to AS2.
b. If the decrease lasts for an extended period the self-correcting mechanism will bring the
economy back to full employment as wages rise, and shift the AS curve back up to AS1.
c. The Fed would reduce the money supply to move the economy away from point (B). This
would shift the AD curve from AD1 to AD2, and the economy would end up at point (C),
rather than at point (A).
Challenge Questions
2.
The Fed countered the downward AS curve shift by increasing the money supply, which led to an
increase in AD. Although the downward AS curve shift put downward pressure on the price level,
this was offset by the upward pressure on the price level from the increase in AD.
Economic Application Exercises
2.
The diagram shows this relationship.