Download Chapter 29 AS-AD and the Business Cycle

Chapter 29
AS-AD and the Business Cycle
29.1 Business-Cycle Definitions and Facts
1) What is a business cycle? What are its phases and turning points?
Answer: A business cycle is the periodic but irregular up-and-down movement in production
and jobs. It has two phases and two turning points. As the economy slows and the
growth in real GDP turns negative, the economy enters the recession phase of the
business cycle. At the bottom of the recession phase is one turning point, the trough.
As the economy moves through the trough, it enters the expansion part of the
business cycle during which real GDP grows. Finally, as the economy reaches its
high point and swings from an expansion to a recession, the economy passes through
the other turning point, the peak.
Topic: Business cycle
Skill: Level 1: Definition
Objective: Checkpoint 29.1
Author: AA
2) What is the NBER's definition of recession? Discuss the relationship between the phases of
the business cycle, real GDP and unemployment in the context of the United States
economy from 1992 to the present.
Answer: The NBER defines a recession as a period of significant decline in total output,
income, employment, and trade, usually lasting at least six months to a year, and
marked by widespread contractions in many sectors of the economy. From 1992 to
until March, 2001, the economy was in an expansion. Then, the last U.S. recession
started in March, 2001 and ended at the trough in November, 2001. During the
expansion that ended in 2001, real GDP rose above potential GDP and
unemployment generally fell to low levels. In the recession, real GDP fell below
potential real GDP and unemployment rose so that it was greater than the natural
rate of unemployment. After the recession ended in November, 2001 real GDP grew
and the unemployment rate fell, though the growth in real GDP and the fall in
unemployment were both slow.
Topic: Business cycle
Skill: Level 2: Using definitions
Objective: Checkpoint 29.1
Author: CT
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3) When total output, income, employment, and trade decline for 6 to 12 months, the economy
is in what part of the business cycle?
Answer: When these real variables decline, the economy is in the recession phase of the
business cycle.
Topic: Business cycle
Skill: Level 2: Using definitions
Objective: Checkpoint 29.1
Author: MR
4) How does the average length of economic expansions and economic recessions in the
United States in the last half of the twentieth century compare with the average length
during other periods of U.S. history?
Answer: The average length of expansions in the last half of the twentieth century has been
much longer than at any other time in U.S. history. Correspondingly, the average
length of recessions in the last half of the twentieth century has been much shorter
than at any other time in U.S. history.
Topic: Business cycle
Skill: Level 1: Definition
Objective: Checkpoint 29.1
Author: AA
29.2 Aggregate Supply
1) Name the four factors of production that determine the quantity of real GDP supplied.
Which one fluctuates the most over the course of the business cycle?
Answer: The factors are the quantity of labor employed, the quantities of capital and human
capital and the technologies they employ, the quantities of land and natural
resources, and the amount of entrepreneurial talent available. Over the course of a
business cycle, the quantity of labor employed fluctuates the most.
Topic: Aggregate supply
Skill: Level 1: Definition
Objective: Checkpoint 29.2
Author: NAU
2) What factor changes the quantity of real GDP supplied and results in a movement along the
AS curve?
Answer: Changes in the price level change the quantity of real GDP supplied and result in a
movement along the AS curve.
Topic: Aggregate supply, price level
Skill: Level 1: Definition
Objective: Checkpoint 29.2
Author: TPS
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3) Does a rise in the price level bring a movement along the aggregate supply curve or does it
shift the aggregate supply curve?
Answer: A rise in the price level results in an upward movement along the aggregate supply
curve. It does not shift the aggregate supply curve.
Topic: Aggregate supply, price level
Skill: Level 1: Definition
Objective: Checkpoint 29.2
Author: DMC
4) If the money wage rate is constant and the price level increases, what happens to the real
wage rate, firms' profits, and the aggregate quantity supplied?
Answer: The real wage rate falls. Because the price level has increased and money wage rates
are constant while real wage rates are lower, firms' profits increase. As a result, the
aggregate quantity of goods and services supplied increases.
Topic: Aggregate supply, price level
Skill: Level 3: Using models
Objective: Checkpoint 29.2
Author: WM
5) List three changes that lead to a shift of the aggregate supply curve. Discuss why each
change shifts the aggregate supply curve and in which direction the curve shifts.
Answer: A change in potential GDP, a change in the money wage rate, and a change in the
money prices of other resources shift the aggregate supply curve. If potential GDP
increases (decreases) or the money wage rate decreases (increases) or the money
prices of other resources decrease (increase), aggregate supply increases (decreases)
and the AS curve shifts rightward (leftward).
Topic: Changes in aggregate supply
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: CT
6) How does a fall in the money wage rate affect the aggregate supply curve?
Answer: A fall in the money wage rate lowers firms' costs and shifts the aggregate supply
curve rightward.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: DMC
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Bade/Parkin œ Foundations of Economics, Third Edition
7) Give examples of factors that decrease aggregate supply. Which way does the AS curve
shift?
Answer: Aggregate supply decreases if potential GDP decreases. A rise in the money wage
rate or the money price of other resources such as the price of oil raises firms' costs
and decreases aggregate supply. The AS curve shifts leftward.
Topic: Aggregate supply curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: TPS
8) What is the effect on aggregate supply and potential GDP of an increase in the money wage
rate?
Answer: An increase in the money wage rate decreases aggregate supply and shifts the
aggregate supply curve leftward. It has no effect on potential GDP.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: AA
9) "Moving along the AS curve, the real wage rate is constant while moving along the
potential GDP line, the real wage rate changes." Explain whether the previous statement is
correct or incorrect.
Answer: The statement is incorrect. It reverses the situation. Moving along the AS curve, the
money wage rate is constant and so the real wage rate changes. Moving along the
potential GDP line, money wage rates have adjusted to the change in the price level
and so the real wage rate is constant.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: MR
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10) What can lead to the shift illustrated in the figure above?
Answer: A decrease in the money wage rate or in the money prices of other resources, such as
the price of oil, increase aggregate supply and shift the AS curve rightward while not
changing potential GDP.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 3: Using models
Objective: Checkpoint 29.2
Author: MR
538
Bade/Parkin œ Foundations of Economics, Third Edition
11) In the above figure, illustrate the effect on the AS curve from an increase in the money price
of a key resource such as oil.
Answer:
An increase in the money price of a key resource such as oil squeezes firms' profits
and decreases aggregate supply. As illustrated in the figure above, the AS curve
shifts leftward, in the figure from AS 1 to AS2.
Topic: Changes in aggregate supply, money prices of resources
Skill: Level 3: Using models
Objective: Checkpoint 29.2
Author: WM
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29.3 Aggregate Demand
1) What is the effect on the aggregate demand curve from an increase in the price level? In
particular, does the aggregate demand curve shift leftward or rightward?
Answer: When the price level increases, there is a movement along the aggregate demand
curve. The quantity of real GDP demanded decreases in response to an increase in
the price level. However, the aggregate demand curve does not shift.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
2) How does an increase in the price level affect the aggregate quantity of goods and services
demanded?
Answer: An increase in the price level decreases the aggregate quantity of goods and services
demanded for three reasons. First, it decreases the buying power of money. As a
result, people decrease their demand for goods and services. Second, it raises the real
interest rate. The real interest rate rises because an increase in the price level
increases the demand for money, which raises the nominal interest rate, which, in the
short run, raises the real interest rate. When the real interest rate rises, people and
businesses delay plans for investment and purchases of big-ticket items. Finally, an
increase in the price level makes domestically produced goods and services more
expensive relative to foreign-produced goods and services. As a result, people and
firms buy more foreign produced and fewer domestically produced goods and
services, which decreases the quantity demanded of domestically produced goods
and services.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
3) Explain the difference between a movement along the aggregate demand curve and a shift
of the aggregate demand curve.
Answer: There is a movement along the aggregate demand curve if there is a change in the
price level. If some factor that affects aggregate demand other than the price level
changes, such as monetary or fiscal policy, income in the rest of the world, or
expectations, there is a shift in the aggregate demand curve.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: NAU
540
Bade/Parkin œ Foundations of Economics, Third Edition
4) How does the aggregate demand curve reflect an increase in aggregate demand?
Answer: An increase in aggregate demand means that the aggregate demand curve shifts
rightward.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: DMC
5) State how each of the following affect the aggregate demand curve.
a. The price level increases.
b. Consumers expect higher inflation in the future.
c. The exchange rate rises.
d. Foreign income decreases.
Answer: a. There is a movement upward along the aggregate demand curve. The aggregate
demand curve does not shift.
b. The aggregate demand curve shifts rightward.
c. The aggregate demand curve shifts leftward.
d. The aggregate demand curve shifts leftward.
Topic: Changes in aggregate demand
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: CT
6) Give examples of factors that decrease aggregate demand. Which way does the aggregate
demand curve shift?
Answer: Anything that decreases spending decreases aggregate demand. A rise in the interest
rate, a decrease in the quantity of money, a decrease in government expenditures or
a tax hike, and a decrease in real GDP in the rest of the world all decrease spending
and decrease aggregate demand. The aggregate demand curve shifts leftward.
Topic: Changes in aggregate demand
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: TPS
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7) How does a rise in the foreign exchange rate affect aggregate demand in the United States?
Explain your answer.
Answer: An increase in the foreign exchange rate decreases U.S. aggregate demand. The
foreign exchange rate is the amount of a foreign currency that a dollar can buy. If the
exchange rate rises, a dollar buys more foreign currency. As a result, foreign goods
and services become cheaper to U.S. citizens because U.S. citizens need to spend
fewer dollars to buy foreign-produced goods and services. Simultaneously,
U.S.-produced goods and services become more expensive to foreigners because
they must spend more of their currency in order to buy the dollars necessary to buy
the U.S.-produced goods and services. As a result, U.S. imports increase and U.S.
exports decrease, both of which decrease U.S. aggregate demand.
Topic: Changes in aggregate demand, foreign exchange rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
8) How does a recession in Asia affect U.S. aggregate demand and the U.S. aggregate demand
curve?
Answer: A recession in Asia means that Asians purchase fewer U.S.-made goods and services.
As a result, U.S. exports decrease so that U.S. aggregate demand decreases and the
U.S. aggregate demand curve shifts leftward.
Topic: Changes in aggregate demand, world income
Skill: Level 3: Using models
Objective: Checkpoint 29.3
Author: NAU
9) "An increase in Mexican income decreases aggregate demand in the United States." Is the
preceding statement correct or incorrect? Briefly explain your answer.
Answer: The statement is incorrect. An increase in Mexican income means that Mexican
citizens buy more goods and services exported from the United States. The increase
in U.S. exports increases U.S. aggregate demand.
Topic: Changes in aggregate demand, world income
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
542
Bade/Parkin œ Foundations of Economics, Third Edition
10) What are the two channels through which the world economy can affect U.S. aggregate
demand? State what changes in the world economy can increase U.S. aggregate demand.
Answer: The world economy can affect aggregate demand through the foreign exchange rate
and foreign income. If the foreign exchange rate falls, then U.S. aggregate demand
increases because U.S. exports become cheaper to foreign residents while U.S.
imports become more expensive to U.S. citizens. If foreign income increases, then
U.S. aggregate demand increases because foreign citizens will spend some of their
increased income on U.S.-produced goods and services.
Topic: Changes in aggregate demand, world economy
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: CT
11) "The aggregate demand multiplier results in the aggregate demand curve shifting by more
than any given initial change in expenditure." Is the previous statement correct or incorrect?
Answer: The statement is correct. The implication is that a, say $10 billion increase in
investment shifts the aggregate demand curve rightward by more than $10 billion.
Topic: Aggregate demand multiplier
Skill: Level 1: Definition
Objective: Checkpoint 29.3
Author: NAU
12) What is the aggregate demand multiplier and why does it occur?
Answer: The aggregate demand multiplier is an effect that magnifies changes in expenditure
plans. So, for example, if some component of expenditure such as investment
increases, aggregate demand increases by more than the increase in investment. The
aggregate demand multiplier exists because when aggregate demand increases,
households' incomes increase. Then the increase in income results in an increase in
consumption expenditure, which adds to the initial increase in aggregate demand.
Topic: Aggregate demand multiplier
Skill: Level 1: Definition
Objective: Checkpoint 29.3
Author: TPS
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29.4 Understanding the Business Cycle
1) What two variables are determined in an aggregate supply-aggregate demand figure? Is
the slope of the aggregate supply curve positive or negative? Is the slope of the aggregate
demand curve positive or negative?
Answer: The aggregate supply-aggregate demand framework determines the equilibrium
price level and equilibrium real GDP. The aggregate supply curve is positively
sloped, indicating that an increase in the price level increases the aggregate quantity
of goods and services supplied. The aggregate demand curve is negatively sloped,
indicating that an increase in the price level decreases the aggregate quantity of
goods and services demanded.
Topic: Aggregate supply and aggregate demand model
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: WM
2) Explain how changes in foreign income can impact real GDP in a country.
Answer: Changes in the income of any nation impact the level of exports and imports of all
other nations trading with it. For example, in the United States aggregate demand
increases if the income of our trading partners, such as Mexico and Canada, increases
because some of the increase in Mexican and Canadian income translates into buying
goods and services imported from the United States. As a result, U.S. aggregate
demand increases, which means that U.S. real GDP increases. Thus increases in
foreign income increase domestic real GDP while decreases in foreign income
decrease domestic real GDP.
Topic: Aggregate demand fluctuations
Skill: Level 4: Applying models
Objective: Checkpoint 29.4
Author: AA
3) How does a cut in interest rates that increases investment affect the quantity of real GDP
demanded, the aggregate demand curve, real GDP, and the price level?
Answer: The increase in investment increases the aggregate quantity demanded and shifts the
AD curve rightward. As a result, the equilibrium price level rises and the equilibrium
real GDP increases.
Topic: Aggregate demand fluctuations
Skill: Level 4: Applying models
Objective: Checkpoint 29.4
Author: DMC
544
Bade/Parkin œ Foundations of Economics, Third Edition
4) State how shifts in the aggregate demand curve can explain the movement of real GDP
around potential GDP.
Answer: When the aggregate demand curve and the aggregate supply curve intersect at the
level of potential GDP, then real GDP is equal to potential GDP. When something
shifts the aggregate demand curve rightward, then the aggregate demand curve and
the aggregate supply curve will intersect at a level of real GDP that is above potential
GDP. The economy will be in an expansion. When something shifts the aggregate
demand curve leftward, then the aggregate demand curve and the aggregate supply
curve will intersect at a level of real GDP that is below potential GDP. The economy
will be in a recession.
Topic: Aggregate demand fluctuations
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: NAU
5) Can actual real GDP exceed potential GDP?
Answer: Yes, actual real GDP temporarily can exceed potential GDP as the economy nears a
business cycle peak.
Topic: Business cycles
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: DMC
6) Define potential GDP. Under what circumstances does actual real GDP fall short of
potential GDP, equal potential GDP, and exceed potential GDP?
Answer: Potential GDP is the level of real GDP that the economy produces when it is at full
employment. Potential GDP can be contrasted with actual real GDP, the amount of
real GDP the country actually produces. Actual real GDP can be less than potential
GDP when the economy is producing at less than full employment, that is, when
there is less than full employment in the labor market. Actual real GDP equals
potential GDP when the economy is producing at full employment. Actual real GDP
can exceed potential GDP temporarily as the economy approaches and then recedes
from a business cycle peak.
Topic: Business cycles
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: CT
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7) Explain how fluctuations in aggregate supply impact real GDP.
Answer: Fluctuations in aggregate supply result in changes in real GDP. If potential GDP
grows at an uneven pace, real GDP fluctuates. Such a situation could be caused by a
rapid technological change such as was the case during the second half of the 1990s,
when potential GDP grew quite rapidly. In addition, price hikes for important
natural resources, such as oil, can create drastic fluctuations in aggregate supply. In
this case, real GDP decreases and the economy enters a recession. Such a recession
occurred in the United States during the mid-1970s and then again in the early 1980s.
Topic: Aggregate supply fluctuations
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: AA
8) Define "stagflation" and explain how it can be created.
Answer: Stagflation is a combination of two words: stagnation and inflation. Stagnation
means real GDP is below the full employment level and falling, that is, the economy
is in recession while at the same time the price level is rising, that is, the economy is
experiencing inflation. An increase in the price of a major resource that decreases
aggregate supply can trigger stagflation.
Topic: Stagflation
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: AA
9) What is an inflationary gap and how does the price level change? What is a deflationary
gap and how does the price level change?
Answer: An inflationary gap occurs when equilibrium real GDP (determined where the
aggregate demand curve intersects the aggregate supply curve) exceeds potential
GDP. When an inflationary gap exists, the price level rises. A deflationary gap occurs
when equilibrium real GDP (determined where the aggregate demand curve
intersects the aggregate supply curve) is less than potential GDP. When a
deflationary gap exists, the price level falls.
Topic: Inflationary gap and recessionary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: TPS
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Price level
(GDP deflator,
2000 =100)
115
110
105
100
95
90
Quantity of real
GDP demanded
(trillions of
2000 dollars)
6.8
9.4
10.0
10.6
11.2
11.8
Quantity of real
GDP supplied
(trillions of
2000 dollars)
12.0
11.0
10.0
9.0
8.0
7.0
10) Based on the table above,
a. What is the equilibrium price level and real GDP?
b. If potential GDP is $11.0 trillion, what does that imply about the economy's level of
employment?
c. If potential GDP is $9.0 trillion, what does that imply about the economy's level of
employment?
Answer: a. The equilibrium price level is 105; the equilibrium real GDP is $10.0 trillion.
b. If potential GDP is $11.0 trillion, then the economy is at an equilibrium that is a
below full-employment equilibrium with a recessionary gap.
c. If potential GDP is $9.0 trillion, then the economy is at an equilibrium that is an
above full-employment equilibrium with an inflationary gap.
Topic: Inflationary gap and recessionary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
11) How might an inflationary gap arise? How does the economy adjust to an inflationary gap?
Answer: An inflationary gap arises when aggregate demand increases and real GDP exceeds
potential GDP. With an inflationary gap, the price level has increased. These higher
prices lead to workers demanding higher wage rates. As firms increase money wage
rates, aggregate supply decreases so that real GDP decreases. Eventually, real GDP
decreases enough so that it equals potential GDP and the economy is back at its full
employment equilibrium.
Topic: Inflationary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
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12) Assume the equilibrium price level is 140 and the equilibrium real GDP is $15 trillion. What
happens if the current price level equals 125?
Answer: The quantity of real GDP demanded is greater than the quantity of real GDP
supplied so there is an inflationary gap. The price level rises to 140 because of the
excess aggregate demand and when the price level reaches 140, macroeconomic
equilibrium is established. The rise in the price is inflation.
Topic: Inflationary gap
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: TPS
13) Suppose that during 2005, the actual real GDP of Chile was 3.5 billion pesos at the same
time the potential GDP was 3.4 billion pesos. What sort of equilibrium existed in Chile?
Answer: Chile's actual real GDP exceeded its potential GDP, so Chile was in an above
full-employment equilibrium with an inflationary gap.
Topic: Inflationary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
14) When the aggregate supply curve intersects the aggregate demand curve at a level of real
GDP that exceeds potential GDP, is there an inflationary gap or a deflationary gap? What
adjustments will take place?
Answer: There is an inflationary gap because real GDP exceeds potential GDP. In this
situation, the money wage rate will rise, shifting the aggregate supply curve leftward
and raising the price level. Eventually the economy will return to potential GDP. At
this time, real GDP is lower than when the inflationary gap existed but the price level
is higher.
Topic: Inflationary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: DMC
548
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15) The economy is at full employment and then aggregate demand increases. Describe what
happens as an immediate result of the increase in aggregate demand. Describe how the
economy adjusts back to full employment.
Answer: The immediate effect of an increase in aggregate demand is to increase both the price
level and real GDP. The money wage rate does not change, so with the higher price
level the real wage rate falls. Eventually, however, workers demand a higher
(money) wage rate to compensate for the higher price level. As firms pay the higher
money wage rate, aggregate supply decreases. The decrease in aggregate supply
means that the price level rises and real GDP decreases. Workers continue to demand
a higher money wage rate and aggregate supply continues to decrease until finally
the economy returns to full employment. At that point, the money wage rate has
increased enough so that the real wage rate is back to its initial level. Real GDP once
again equals potential GDP, so the changes in real GDP were only temporary. The
price level, though, is higher than its initial level, so the increase in the price level is
permanent.
Topic: Inflationary gap
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: WM
16) What is a recessionary gap? Can a recessionary gap arise from a decrease in aggregate
demand?
Answer: A recessionary gap exists when potential GDP exceeds real GDP. A recessionary gap
can arise from a decrease in aggregate demand because the decrease in aggregate
demand decreases real GDP.
Topic: Recessionary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
17) If real GDP is less than potential GDP, what type of gap is the economy experiencing?
Answer: When real GDP is less than potential GDP, the economy is experiencing a
recessionary gap.
Topic: Recessionary gap
Skill: Level 1: Definition
Objective: Checkpoint 29.4
Author: WM
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18) What is the current equilibrium price level and real GDP for the economy illustrated in the
figure above? Does this economy have an inflationary gap, a recessionary gap, or neither?
As it adjusts toward full employment, which curve shifts? What is the equilibrium real GDP
and price level that the economy will ultimately reach?
Answer: The equilibrium is where the aggregate demand and aggregate supply curves
intersect. Thus the equilibrium price level is 110 and equilibrium real GDP is $10
trillion. Real GDP exceeds potential GDP, so the economy has an inflationary gap.
The aggregate supply curve will shift leftward as the economy adjusts to full
employment. Ultimately the aggregate supply curve will shift so that it intersects the
aggregate demand curve where the aggregate demand curve crosses the potential
GDP line. Thus ultimately equilibrium real GDP equals potential GDP, $9.5 trillion,
and the price level is 120.
Topic: Inflationary gap
Skill: Level 4: Applying models
Objective: Checkpoint 29.4
Author: WM