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Study Guide ECON 301 Intermediate Macroeconomics Aggregate Demand, Aggregate Supply, Short Run and Medium Run True, False, or Uncertain? Explain with words and graphs. If statement is false, say why it is false, and what is the truth. If it is true, explain why it is true. If it is uncertain, explain what would have to be the case for the statement to be true. Aggregate Demand 1. To obtain the Aggregate Demand curve, we find the level of output that yields equilibrium in the money market (LM curve) and the goods market (IS curve) simultaneously, and then allow expected inflation (
) to change exogenously to yield different levels of equilibrium output. The resulting expected inflation‐output combinations are graphed as the AD curve. 2. To obtain the Aggregate Demand curve, we find the level of output that yields equilibrium in the money market (LM curve) and the goods market (IS curve) simultaneously, and then allow actual inflation ( ) to change exogenously to yield different levels of equilibrium output. The resulting inflation‐output combinations are graphed as the AD curve. 3. To obtain the Aggregate Demand curve, we find the level of output that yields equilibrium in the money market (LM curve) and the goods market (IS curve) simultaneously, and then allow interest rates (i) to change exogenously to yield different levels of equilibrium output. The resulting interest rate‐output combinations are graphed as the AD curve. 4. The aggregate demand curve is a relation between the real money supply and output demanded: a real monetary expansion leads to lower interest rates, higher investment, higher expenditure, and higher output. 5. The aggregate demand curve is a relation between interest rates and output demanded: a reduction in the interest rate leads to higher investment, higher expenditure, and higher output. True, False, or Uncertain? Explain with words and graphs 6. The aggregate demand curve is a relation between the inflation rate and output demanded: lower inflation makes goods cheaper, which increases output demanded, so that the AD curve is downward sloping. 7. The aggregate demand curve is a relation between the inflation rate and output demanded: higher inflation encourages people to spend more today, before goods become even more expensive, so that the AD curve is upward sloping. 8. The aggregate demand curve is a relation between the inflation rate and output demanded: higher inflation, for a given rate of growth of nominal money supply, pushes down the real money supply, increases interest rates, reduces investment and output demanded, so that the AD curve is downward sloping. 9. The aggregate demand curve is a relation between the inflation rate and output demanded: higher inflation, for a given expected inflation rate, increases unemployment, reduces real wages, and pushes down real demand for output. 10. The aggregate demand curve shifts to the left when inflation rises because higher inflation reduces the real money supply, raises interest rates, and lowers investment and output. 11. The aggregate demand curve shifts to the left as a response to higher expected inflation because higher reduces the real money supply, raises interest rates, and lowers investment and output. 12. The aggregate demand curve shifts to the left when money supply falls (if inflation is unchanged) because in that case the real money supply falls, raising interest rates, and lowering investment and output. 13. Any increase in spending that is not caused by changes in inflation shifts the AD curve to the right. True, False, or Uncertain? Explain with words and graphs 14. A reduction in any variable, other than inflation, that shifts the IS or LM curves to the left causes a shift of the AD curve to the left. 15. Lower inflation causes the LM curve to shift up (because the real money supply contracts), reducing output and raising interest rates. 16. Lower inflation causes the LM curve to shift down (because the real money supply expands), raising output and lowering interest rates. 17. Lower inflation causes the IS curve to shift right (because investment contracts), reducing output and raising interest rates. 18. Lower inflation causes the IS curve to shift left (because investment contracts), raising output and lowering interest rates. Aggregate Supply 1. To derive the aggregate supply curve, we find the combinations of output and inflation that make consumers’ decisions consistent with firms’ decisions, resulting in goods‐market equilibrium. 2. To derive the aggregate supply curve, we find the combinations of output and inflation that make workers’ decisions consistent with firms’ decisions, resulting in labor‐market equilibrium. 3. To derive the aggregate supply curve, we find the combinations of output and inflation that make workers’ decisions consistent with consumers’ decisions, resulting in optimal household allocation of time and resources. 4. The aggregate supply curve is a relation between consumer confidence and inflation: higher consumer confidence raises expenditure; this higher demand increases the rate at which firms increase prices. True, False, or Uncertain? Explain with words and graphs 5. The aggregate supply curve is a relation between the availability of resources and inflation: a shock that leads to fewer resources reduces firms’ capacity to produce, so they must charge more for their production. 6. The aggregate supply curve is a relation between output and inflation: higher output reduces unemployment, which allows workers to demand faster raises – at a given expected inflation rate. Higher wages means higher costs of production, which raises inflation. 7. The aggregate supply curve is a relation between taxes and inflation: a tax increase leads to higher costs for business, so that inflation rises at any level of output. 8. The aggregate supply curve is a relation between unemployment and inflation: lower unemployment makes workers more willing to demand higher wages, which raises inflation. 9. The aggregate supply curve is a relation between expected inflation and actual inflation: because the AS curve has to go through the ,
point, higher expected inflation raises ,
point, higher expected inflation raises inflation. 10. Because the AS curve has to go through the output at any level of inflation, which is represented as a shift right of the AS curve. 11. Because the AS curve has to go through the ,
point, higher expected inflation raises inflation at any level of output, which is represented as a shift up of the AS curve. 12. Because the AS curve can deviate from ,
point in the short run (even though it must return to it in the medium run), higher expected inflation raises inflation and lowers output, which is represented as a shift to the left of the AS curve. The Short Run 1. In the short run, the AS curve must go through the 2. In the short run, the AS curve may deviate from the ,
point. ,
point. True, False, or Uncertain? Explain with words and graphs 3. Short‐run equilibrium is determined by the combination of the inflation rate and the level of output that is consistent with simultaneous money‐market equilibrium and goods‐market equilibrium, although the labor market may be out of equilibrium in the short run. 4. Short‐run equilibrium is determined by the combination of the inflation rate and the level of output that is consistent with simultaneous equilibrium in at least two out of these three markets: the money market, the goods market, and the labor market. 5. Short‐run equilibrium is determined by the combination of the inflation rate and the level of output that is consistent with simultaneous money‐market equilibrium, goods‐market equilibrium, and labor‐market equilibrium. 6. In short‐run equilibrium, the AD curve (which represents simultaneous money‐market and goods‐market equilibrium) and the AS curve (which represents labor‐market equilibrium) must ,
intersect at the point to yield simultaneous equilibrium in all three markets. 7. In short‐run equilibrium, the AS curve (which represents simultaneous money‐market and goods‐market equilibrium) and the AD curve (which represents labor‐market equilibrium) must ,
intersect at the point to yield simultaneous equilibrium in all three markets. 8. If the economy is in short‐run equilibrium, it is where both the AD and the AS curves intersect; this may happen away from the ,
point, or at the 9. If the AD and the AS curves intersect at the ,
,
,
point. point (that is, if the economy is at the point), it is not in short‐run equilibrium. 10. In short‐run equilibrium, simultaneous money‐market equilibrium, goods‐market equilibrium, and labor‐market equilibrium may happen where actual output is different from the natural level of output (that is, in the short run, it is possible for expected inflation ), but inflation must equal . True, False, or Uncertain? Explain with words and graphs 11. In short‐run equilibrium, simultaneous money‐market equilibrium, goods‐market equilibrium, and labor‐market equilibrium may happen where inflation is different from expected inflation ), but actual output must equal the natural level (that is, in the short run, it is possible for of output . 12. If in short‐run equilibrium , then it must be true that . 13. If in short‐run equilibrium , then it must be true that . The Medium Run 1. The labor market must be in equilibrium both in the short run and in the medium run. 2. All three markets (goods, money, and labor) must be in equilibrium both in the short run and in the medium run. 3. Although the labor market may be out of equilibrium in the short run, it must be in equilibrium in the medium run. 4. Although the economy may be above or below either the AD or the AS curves (but not both) in the short run, medium‐run equilibrium is always found where both curves intersect. 5. In the short run, the economy must be where both the AD and the AS curves intersect. On the other hand, medium‐run equilibrium may be found off the AD or AS curve (but not both). 6. If the economy is in medium‐run equilibrium, it is where both the AD and the AS curves intersect; this may happen away from the ,
point, or at the ,
point. 7. If the economy is in medium‐run equilibrium, it is where both the AD and the AS curves intersect, at the ,
point. 8. If the AD and the AS curves intersect at the ,
,
point (that is, if the economy is at the point), it is not in medium‐run equilibrium. 9. The medium run is defined as the time when the AS curve returns to the True, False, or Uncertain? Explain with words and graphs ,
point. 10. The medium run is defined as the time when expected inflation has fully adjusted, and is now equal to actual inflation. 11. The medium run is defined as the time when actual output equal to the natural level of output. 12. The medium run is defined as the time when monetary policy fully adjusts to respond to changes in fiscal policy, so that the economy is at the ,
point. 13. The medium run is defined as the time when monetary policy fully adjusts to respond to changes in the natural level of output, so that the economy is at the ,
point. 14. The economy may be away from its medium‐run equilibrium for a while because interest rates take a while to adjust; but adjustments in the interest rate bring output back to the natural level of output. 15. The economy may be away from its medium‐run equilibrium for a while because actual inflation rates take a while to adjust; but adjustments in the actual inflation rate bring output back to the natural level of output. 16. The economy may be away from its medium‐run equilibrium for a while because expected inflation rates take a while to adjust; but adjustments in the expected inflation rate bring output back to the natural level of output. The Opening of an Output Gap 1. If AD shifts left, output will fall, leading to lower inflation. 2. If AD shifts left, output will fall, leading to higher inflation. 3. If AS shifts left, output will fall, leading to higher inflation. 4. If AS shifts left, output will rise, leading to lower inflation. 5. Suppose the economy starts from the ,
point. A leftward shift of either AD or AS opens a recessionary output gap, which means higher inflation. True, False, or Uncertain? Explain with words and graphs 6. Suppose the economy starts from the ,
point. A leftward shift of either AD or AS opens a recessionary output gap, which means lower inflation. 7. Suppose the economy starts from the ,
point. A leftward shift of either AD or AS opens a recessionary output gap, which means higher inflation if it is AS that shifted, and lower inflation if it is AD that shifted. 8. Suppose the economy starts from the ,
point. A rightward shift of either AD or AS opens a recessionary output gap, which means higher inflation if it is AS that shifted, and lower inflation if it is AD that shifted. 9. A monetary expansion raises equilibrium output in the short run. Because this is represented by a shift of the AD curve, the economy moves along the AS curve (higher output, lower unemployment, demands for larger wage raises, higher inflation). Higher inflation (shift up of the LM curve) counteracts the effect of the monetary expansion (shift down of the LM curve): real money supply does not increase at all in the short‐run (keeping the LM curve steady). 10. A monetary expansion raises equilibrium output in the short run. Because this is represented by a shift of the AD curve, the economy moves along the AS curve (higher output, lower unemployment, demands for larger wage raises, higher inflation). Higher inflation (shift up of the LM curve) counteracts the effect of the monetary expansion (larger shift down of the LM curve), but not fully, so that real money supply increases in the short‐run (net shift down of the LM curve), but by less than the increase in nominal money supply. 11. A monetary expansion raises equilibrium output in the short run. Because this is represented by a shift of the AD curve, the economy moves along the AS curve (higher output, lower unemployment, demands for larger wage raises, higher inflation). Higher inflation (shift up of the LM curve) more than offsets the effect of the monetary expansion (smaller shift down of the LM curve), so that real money supply decreases in the short run (net shift up of the LM curve). True, False, or Uncertain? Explain with words and graphs 12. Suppose the economy starts from the ,
point. A shock that increases expected inflation (and changes nothing else) leads to lower output. In the short‐run, inflation rises, but by less than expected inflation. 13. Suppose the economy starts from the ,
point. A shock that increases expected inflation (and changes nothing else) leads to lower output. In the short‐run, inflation rises by more than expected inflation. 14. Suppose the economy starts from the ,
point. A shock that increases the natural level of output (and changes nothing else) leads to lower inflation. In the short‐run, output rises, but by less than the increase in the natural level of output, so that 15. Suppose the economy starts from the ,
. point. A shock that increases the natural level of output (and changes nothing else) leads to lower inflation. In the short‐run, output rises by the same amount as the increase in the natural level of output. Adjustment to the Medium Run 1. If the economy’s short‐run equilibrium is away from the ,
point, medium‐run equilibrium will be restored by gradual adjustments in the expected inflation rate. 2. If the short‐run equilibrium inflation rate is below the expected inflation rate , medium‐run equilibrium will be restored when the inflation rate rises. 3. If the short‐run equilibrium inflation rate is below the expected inflation rate , medium‐run equilibrium will be restored when the expected inflation rate falls. 4. If the short‐run equilibrium inflation rate is below the expected inflation rate , equilibrium output will rise on its way back to medium‐run equilibrium. 5. If the short‐run equilibrium inflation rate is below the expected inflation rate equilibrium output will fall on its way back to medium‐run equilibrium. True, False, or Uncertain? Explain with words and graphs , 6. If short‐run equilibrium output is below the natural level of output , then it must be true that the short‐run equilibrium inflation rate is below the expected inflation rate , so that inflation will rise on its way back to medium‐run equilibrium. 7. If short‐run equilibrium output is above the natural level of output , then it must be true that the short‐run equilibrium inflation rate is above the expected inflation rate , so that expected inflation will rise on its way back to medium‐run equilibrium. Because the AS curve has to go through the ,
point, higher raises inflation. 8. If short‐run equilibrium output is below the natural level of output , then it must be true that the short‐run equilibrium inflation rate is below the expected inflation rate , so that expected inflation will fall on its way back to medium‐run equilibrium. Because the AS curve has to go through the ,
point, lower lowers inflation. 9. Suppose an expansionary shock has increased output above the natural level of output . More production leads to lower inflation (because an excess of output over the natural level of output indicates greater productivity, which implies lower business costs). As actual inflation falls, output falls because (for a constant rate of increase of business costs) firms are not able to stay profitable with smaller price increases. This allows output to return to medium‐
run equilibrium. 10. Suppose an expansionary shock has increased output above the natural level of output . The higher level of expenditure and demand will encourage firms to increase their productivity, so that the natural level of output will rise, which brings down inflation. This process continues until the expected inflation rate also falls, which eventually leads output to return to the natural level of output. 11. If , unemployment will encourage workers to accept smaller raises, which allows firms to pass on smaller price increases to consumers: inflation will be below expected inflation True, False, or Uncertain? Explain with words and graphs . Eventually, expected inflation will fall as workers revise their expectations. As expected inflation falls, workers accept smaller raises (of their wages and salaries), which allows firms to lower the inflation rate (the rate of their price increases). Lower inflation makes the real money supply larger (for any constant monetary policy), so that investment and expenditure rise: output rises. Expected inflation will keep falling as long as , raising output. The process continues until the natural level of output is reached. At this point, and the economy is in medium‐run equilibrium. Medium‐Run Effects of Shocks 1. In the medium‐run, inflation rises to fully offset a monetary expansion: comparing the initial point and the final medium‐run position, there is no change in real money supply, interest rates, output, or the components of expenditure. The only medium‐run effect of a monetary expansion (a shift right of the LM curve) is higher inflation (an identical shift left of the LM curve). 2. In the medium‐run, inflation rises to offset a monetary expansion, but less than fully: comparing the initial point and the final medium‐run position, real money supply, output, and inflation rise. Higher inflation makes investment fall (a shift left of the IS curve) after a monetary expansion (a shift right of the LM curve) so that interest rates decline, and there is more investment in the medium‐run. 3. In the medium‐run, inflation rises to offset a fiscal expansion (a shift right of the IS curve), but comparing the initial point and the final medium‐run position, inflation rises and so real money supply falls (a shift left of the LM curve). The result is that, interest rates rise but output does not change, so that there is less investment in the medium‐run after a fiscal expansion. True, False, or Uncertain? Explain with words and graphs 4. There is no medium‐run effect of a fiscal expansion on any variable (there is a short‐run effect, however) because the fiscal expansion (short‐run shift right of the IS curve) is fully offset by higher inflation that contracts investment (a medium‐run shift left of the IS curve). 5. There is no medium‐run effect of a shock to expected inflation on any variable (there is a short‐
run effect, however). For example, a decrease in expected inflation lowers inflation, causing expenditure to rise and opening an expansionary output gap. Higher output in the short run causes unemployment to fall below the natural rate of unemployment, so that inflation does not fall as much as expected inflation. In the transition to the medium run, expected inflation begins to rise (as workers realize inflation is higher than expected). Since a shock to expected inflation does not change any real (physical) variable, medium‐run equilibrium is regained when expected inflation returns to the original. 6. In the medium‐run, a shock that increases expected inflation causes inflation to rise (because workers want higher wages), so that the real money supply falls (shift left of the LM curve), increasing interest rates and reducing investment. 7. After an increase in production costs that reduces the natural level of output, inflation rises for any level of actual output. This contracts the real money supply, expenditure, and output. Lower output leads to lower inflation. Lower inflation undoes the increase in production costs and pushes the natural level of output back to the original position, so that in the medium run the economy returns to the original point. 8. After an increase in production costs that reduces the natural level of output, inflation rises for any level of actual output. This contracts the real money supply, expenditure, and output, so that inflation does not rise by as much. As expected inflation adjusts upward to catch up with actual inflation, output keeps falling until its equal to the new, lower, level of natural output. True, False, or Uncertain? Explain with words and graphs