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AK Macroeconomics – Chapter 13
CHAPTER THIRTEEN
Answers to Self-Test Questions
1. The Neoclassical aggregate supply curve is vertical at the full-employment level of
GDP because they argue that only real factors have an effect on capacity GDP.
Changes in aggregate demand and prices have no effect on the full-employment level
of GDP.
2. A decrease in the demand for loanable funds (for investment) or an increase in the
supply of loanable funds (from savers) will cause a decrease in interest rates.
3. a) wage rate: $7; workers employed: 12 million
b) employed: 10.8; unemployed: 2.7
c) Since employment dropped from 12 million to 10.8 million, 1.2 million have lost
their jobs. The rest of the unemployed, 1.5 million, are the result of more people
looking for jobs (quantity supplied increased from 12 to 13.5 million).
4. Keynes suggested that interest rates have little or no effect upon the level of savings.
First, he argued that income is by far the major determinant of savings, and second
because, if income remains the same, an increase in savings means a drop in
consumption and such a drop is painful for most people because it involves a change
in habits and in lifestyles.
5. According to Keynesian theory, an increase in aggregate demand will cause an
increase in real GDP (except at full employment). Since the price level remains
constant, it will also cause an increase in nominal GDP.
6.
Real GDP will rise as will the price level. The unemployment rate will fall.
7.
Fiscal policy will be more effective because the expansionary monetary will prevent
interest rates from rising and this will mean that there is no crowding out of
investment spending as a result of higher aggregate demand.
8. The first blunder was the commonly held (erroneous) belief that the housing marke
was a safe investment because housing prices never fall. The second blunder was the
belief (again erroneous) that financial markets need not be regulated by the
government. The third blunder was due to the fact that no institution took
responsibility for the way in which trillions of dollars in investment was handled.
9. The reason that Canada’s Action Plan emphasized fiscal rather than monetary policy
is because interest rates were already extremely low in Canada and it was felt that
there would be little to be gained by decreasing them further.
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Answers to Study Guide Questions
1. True
2. False: they felt that it was vertical at the full-employment GDP level.
3. True
4. True
5. True
6. False: they are ineffective in curing stagflation.
7. False: it is based on the relationship between inflation and unemployment levels.
8. True
9. False: They are associated with the financial crisis of 2008-10..
10. False: It has varied considerably in the last twenty years.
11. b
12. b
13. b
14. b
15. c
16. b
17. a
18. b
19. e
20. a
21. e
22. c
23. d
24. d
25. d
26. d
27. c
28. d
29. b
30. b
31. b
32. a
33. d
34. d
35. c
36A. Key Problem
a) See the following figure:
Figure 13.8 (completed)
b) The AD curve shifts to the right by 6 squares in Figure 13.12 (completed) .
(Since aggregate demand changes by $20 billion for every 1% change in taxes, a
6% decrease in taxes will cause a $120 billion increase in aggregate demand.)
c) Real GDP has increased by $40, and the price level has increased by 16 points.
Reading the graph in Figure 13.8 (completed) shows that the new equilibrium is at
a real GDP level of $640 and a price level of 116.
d) The AS and the Potential GDP curves shift to the right by 1.5 squares as
shown in Figure 13.12 (completed). Since aggregate supply changes by $5 billion
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for every 1% change in taxes, a 6% decrease in taxes will cause a $30 billion
increase in both the aggregate supply and Potential GDP curves.
e) Real GDP has increased by $20, and the price level has decreased by 4 points.
Ignoring the new AD2 curve, Figure 13.8 (completed) shows that the increase in
the aggregate supply curve to AS2 which would bring about a new equilibrium at
a real GDP level of $620 and a price level of 96.
f) The total increase is the sum of the aggregate demand increase of $40 and the
aggregate supply increase of $20. The two together would therefore increase
real GDP by $60. The increase in aggregate demand pushes up the price level by
16 points whereas the increase in the aggregate supply pushes the price level
down by 4 points. Overall, therefore, the price level has increased by 12 points.
g) Inflationary gap of $20.
The Potential GDP initially was at the $610 level of real GDP. (Equilibrium was
at $600, and the introduction to the question said there was a $10 recessionary
gap.) The decrease in taxation shifted both the AS and the Potential GDP curves
since it increased the productivity of Copland. The new Potential GDP curve
therefore increases by $30 and is located at the $640 level of GDP. Since
equilibrium (the intersection of AD2 and AS2) is at $660, there is an inflationary
gap.
37A. a)
b)
c)
d)
e)
38A. 1. B
rate of interest: 8%;
rate of interest: 7% (At 7% savings equals 100);
rate of interest: 10% (At 10% investment equals 100);
change in savings: + $60 (shift S curve 3 squares right) ;
new level of savings/investment: $140;
change in investment:  $60 (shift I curve 3 squares left);
new level of savings/investment: $80
2. D
3. C
4. A
39A. Say’s Law is: supply creates its own demand. It means that the act of production
(supply) creates an equal amount of income which in turn produces sufficient
spending (demand) to purchase that production.
40A.
Both decades---the 3rd one in the 20th century and the 1st one in the
21st were "go-go" decades fueled by the expansion of a financial
bubble (stocks in the first case and then property in the second) and
in each case the bubble burst with a serious recession to follow.
41A. With the outbreak of WW II, aggregate demand increase dramatically as military
spending increased. This shifted the AD curve to the right sufficiently to return the
economy to full employment quite quickly.
42A. The Canadian economy was the first of the G-20 nations to pull out of the recession
and its recovery was among the strongest.
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43A. Unemployment is voluntary according to neoclassical theory because it is believed
that markets in general, and the labour market in particular, are perfectly competitive.
Unemployment (a surplus of labour) therefore can only occur if the prevailing wage
rate is above the equilibrium rate. This would normally cause the wage rate to drop
and for the surplus of labour to disappear as firms hire more workers. But since this
is not happening, it must be because the unemployed workers are refusing to work at
lower wages. If this is so, then that must be their individual choice, i.e., they choose
to be unemployed, voluntarily.
44A. a) No, (there is a surplus and) prices will fall to 100 (This is because the fullemployment equilibrium is at a price of 100 and GDP of $350 which implies a
surplus at a price of 110.)
b) No change in real GDP, and prices rise to 105. (Think of the AS being a vertical
line at 35; an increase of AD by 50 shifts the AD curve right one square).
c) real GDP: 250 (This is the amount of GDP at the price of $110, which means it is
below the full-employment level of $350.)
d) GDP rises to 300, and prices stay at 110. (Think of AS as a horizontal line at a
price of 110; an increase of AD one curve to the right).
45A. Keynesians see the effect of increased savings to be a decrease in consumption
spending and, therefore, in national income. Neoclassicists see the effect of increased
savings to be a decrease in interest rates and, therefore, an increase in investment
spending and national income.
46A. Expansionary economic policy could increase real GDP while leaving the price
level unchanged if the AS curve is horizontal (i.e. if the economy is in a recession).
47A. Since Keynesians believe that prices are constant (“sticky”) in the short-run, a
reduction in aggregate demand will have no effect on the price level but will reduce
GDP by the amount of the fall in aggregate demand.
48A. Canada was the first of the G20 nations to recover from the recession of 2008-10
for two primary reasons. The first was the fact that Canada’s banking system
remained very much intact during the financial crisis since the use of risky sub-prime
mortgages and mortgage based derivatives was either prohibited by regulation or
avoided. Second, the federal government’s fiscal policy response to the emergence of
the recession in Canada was, in proportion to the size of the economy, the largest of
any nations in the G 20.
49A. The first reason put forward in favour of a policy to reduce deficits was that,
unlike the 1930s when running a deficit might have been an acceptable way of
helping to recover from the Depression, the situation in 2009 was vastly different
since the deficit and debt levels of most countries was immeasurably higher.
Secondly, many questioned the effectiveness of expansionary fiscal policy because
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they believed the multiplier to be quite small. Thirdly, it was suggested that though
budget deficits might occasionally be acceptable in the short-run, they did a great deal
of damage to the economy in the long-run since they tended to encourage
governments to “recklessly overspend”.
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