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Economics 161
E. McDevitt
SQ on the AS/AD model
1. What is the definition of aggregate demand? What are the components of aggregate demand?
2. What relationship is expressed by the aggregate-demand curve? Draw a graph of the AD curve.
3. Why does the aggregate demand curve have a negative slope? Be specific.
4. What are the shift variables for the aggregate-demand curve? Be sure to explain which component of AD
is affected by this variable.
5. What is aggregate supply?
6. Why is the long-run aggregate-supply curve vertical? What factors shift the long-run aggregate-supply
curve? Using a graph with the AD curve and LRAS curve, determine the impact on P and Y in the long run
of the following events: there is an increase in the level of physical and human capital AND at the same
time the money supply increased. If it is observed that P has risen, what does that imply about the relative
shifts in each curve?
7. Why does the short-run aggregate-supply curve slope upwards? What is the significance of an upwardslopping short-run aggregate-supply curve? What factors shift the short-run aggregate-supply curve?
8. Use the following equation to answer the questions below:
Quantity of output supplied (Y) = Natural Rate of Output + a(Actual P - Expected P)
Assume that the natural rate of output is 2000 and that a=1. Assuming that Expected P = 100, fill in the
rest of Table 1. Assuming that Expected P equals 80 fill in the rest of Table 2
Table 1 (Expected P=100)
Actual P
Y .
120
100
80
Table 2 (Expected P = 80)
Actual P
Y .
100
80
60
Draw in the short-run aggregate-supply (SRAS) curve corresponding to Table 1. Draw in the SRAS curve
corresponding to Table 2.
What conclusion do you draw about how the expected price level affects the SRAS curve?
9. Using graphs of the aggregate demand-aggregate supply model, answer each question below.
Discuss the short-run effects.
a. Suppose there is an unexpected drop in the money supply.
b. Assume that consumer wealth unexpectedly rises.
c. Assume that there is a perfectly anticipated increase in G.
d. New and costly government regulations are imposed on producers. The regulations are temporary.
e. A sudden but temporary drop in oil prices.
10. Multiple choice questions. Select the best answer.
10a. The mid-1970s experienced a sharp rise in the price level and a decline in real output. Which of the
following events can best explain this outcome?
a. A drop in consumer confidence that causes a decrease in the AD curve.
b. An oil cutoff that results in a decrease in the SRAS curve.
c. An increase in the money supply that causes an increase in the AD curve.
d. The government temporarily removes burdensome regulations that cause an increase in the SRAS.
10b. The aggregate demand curve shows:
a. the quantity of goods and services that households, firms, and the government want to buy at each
price level.
b. the quantity of goods and services that households, firms, and the government want to buy at each
interest rate.
c. the quantity of goods and services that households want to buy at each price level.
d. The quantity of goods and services that firms want to buy at each interest rate.
e. none of the above.
10c. The aggregate supply-aggregate demand model predicts that the short-run effects of a temporary but
severe oil-cutoff would be:
a. A decrease in the price level and an increase in real output.
b. An increase in both the price level and real output.
c. An increase in the price level and a decrease in real output.
d. A decrease in both the price level and real output.
10d. Which of the following is NOT one of the components of aggregate demand?
a. Consumption spending.
b. Investment spending.
c. Government spending on goods and services.
d. Money supply.
e. Net Exports.
10e. All of the following events would cause a rightward shift in aggregate-demand EXCEPT:
a. A boom in the stock market that raises consumer wealth.
b. An investment tax credit that raises the rate of return on investment.
c. A recession abroad which decreases net exports.
d. The Fed increases the money supply.
e. An increase in government spending.
10f. Which of following help explain the negative slope of the aggregate demand curve?
a. A lower price level increases real wealth, which encourages spending on consumption.
b. A lower price level reduces the interest rate, which encourages spending on investment.
c. A lower price level causes the real exchange rate to depreciate, which encourages spending on net
exports.
d. All of the above.
e. None of the above.
10g. According to the Sticky-Wage Theory an unexpected decrease in the price level will cause:
a.
b.
c.
d.
the nominal wage rate to fall by a proportional amount leaving the real wage rate, employment and real
output unchanged.
The real wage rate to fall, and employment and real output to rise.
The real wage rate to rise, and employment and real output to fall.
The nominal and real wage rate to fall, and employment and real output to rise.
10h. According to the Sticky-Price Theory:
a.
b.
c.
d.
prices of some goods and services adjust slowly over time.
menu costs make it costly for some sellers to immediately adjust price when economic conditions
change.
the short-run aggregate supply curve has a positive slope.
all of the above.
10i. The aggregate supply-aggregate demand model predicts that the short-run effects of an unanticipated
decrease in the expected future profitability of investment projects are:
a. A decrease in the price level and an increase in real output.
b. An increase in both the price level and real output.
c. An increase in the price level and a decrease in real output.
d. A decrease in both the price level and real output.
ANSWERS
1. Aggregate demand refers to quantity of goods and services that households, firms, and the government
want to buy at each price level. Aggregate demand consists of real consumption spending (C) , real
investment spending (I), real government spending on goods and services, and net exports (NX).
2. The aggregate-demand curve shows the relationship between the quantity of goods and services that
households, firms, and the government want to buy and the price level, as in the graph below.
Price Level
P1
P2
Aggregate Demand
Y1
Y2
Quantity of Real Output
3. There are three reasons for this negative slope. a. Wealth Effect: Note that the nominal value of money
is fixed (“ it takes one dollar to buy one dollar”). It therefore follows that a fall in the price level increases
the purchasing power of a given amount of dollars. This makes consumers feel more wealthy, which in
turn encourages consumers to spend more. The increase in the spending means a larger quantity of goods
and services demanded.
In summary: P  purchasing power of money  consumers feel more wealthy C  AD.
b. Interest-Rate Effect: A decrease in the price level causes a decrease in the demand for money. The
public will therefore attempt to reduce their money holdings by purchasing other assets. For example, the
public will convert some of their money into interest-bearing assets, which will lead to a drop in the
interest rate (r) . Lower interest rates, in turn, stimulate borrowing by firms that want to invest in new
capital goods. The increase in investment spending causes aggregate demand to rise.
To summarize: P  Money Demand  Public attempts to reduce their money holdings by purchasing
interest-bearing assets  r   I  AD.
c. Exchange-Rate Effect: This effect will discussed in more detailed in a later lecture. For now, let it
suffice to say that P  E NXAD.
4. Shift variables for AD curve:
a. Shifts from Consumption—Any event that changes how much people want to consume at a given price
level shifts the aggregate-demand curve. Changes in expected-future income (“consumer confidence”),
wealth, and taxes would all affect current consumption spending. For example, suppose new information
leads consumers to expect that their future income will fall (“drop in consumer confidence”). The
resulting drop in consumption spending will cause the aggregate-demand curve to shift to the left. On the
other hand, an increase in consumer confidence will cause the aggregate demand curve to shift to the right.
As another example, suppose that a stock market boom makes people feel wealthier such that consumption
spending rises. This would shift the aggregate demand to the right. As a final example, suppose the
government cuts taxes. This encourages spending which increases aggregate demand.
To summarize: changes in Wealth, Expected-Future Income, and Taxes would all shift the AD curve.
b. Shifts from Investment— Any event that changes how much firms want to invest at a given price level
shifts the aggregate-demand curve. For example, changes in firms’ expectations about future cash flows
from investment projects (EFPI), changes in the tax rate on capital, and changes in the money supply
which lead to short-run changes in the interest rate will all have an impact on current investment spending.
Thus, an increase in business confidence will encourage investment spending. This causes the aggregate
demand curve to shift to the right. Likewise, a reduction in the tax rate on capital will also encourage
investment spending. As a final example, consider the impact of an increase in the money supply. As
explained elsewhere, this will lower the interest rate in the short run. The lower interest rate will stimulate
investment spending, thereby shifting out the aggregate-demand curve.
To summarize: changes in EFPI, government policies that affect the incentive to invest, and the money
supply would all shift the AD curve.
c. Shifts from government spending on goods and services. Changes in government spending on goods
and services will also shift the aggregate-demand curve. For example, an increase in federal spending on
national defense will lead to a rightward shift in the aggregate-demand curve. Changes in spending by other
levels of government would also shift the aggregate demand curve.
d. Shifts arising from net exports. Any event that changes net exports for a given price level also
shifts the aggregate-demand curve. For example, a recession abroad would tend to lower the demand for
domestic goods, so net exports would fall. The fall in net exports would result in a leftward in the
aggregate-demand curve. A change in the exchange rate, E, (for reasons other than that given above in our
discussion of the Exchange-Rate Effect) would also cause a change in net exports. If the dollar appreciates,
domestic goods become more expensive abroad and this would depress net exports. The drop in net exports
would shift the aggregate demand curve to the left. To summarize: changes in E and Other factors that
affect NX would shift the AD curve.
Summary of AD shift variables
Shift variables
Wealth
Component of AD affected
C
Impact on AD
wealth C  AD shifts rightwards
wealth C  AD shifts leftwards
Expected –Future
Income
(“consumer confidence”)
C
ExFutInC  AD shifts rightwards
ExFutInC  AD shifts leftwards
Taxes
C
Taxes C  AD shifts leftwards
Taxes C AD shifts rightwards
EFPI
(“business confidence”)
I
EFPI I AD shifts rightwards
EFPI I  AD shifts leftwards
Gov. Policies that
encourage/discourage investment
I
(example: decrease/increase in tax rate on investment)
.
GovPolEncourageInv I AD shifts to right
GovPolDiscourInv I  AD shifts to the left
Money Supply
I
MSshort-run r IAD shifts to the right
MSshort-run rIAD shifts to the left
G
G
G  AD shifts to the right
GAD shifts to the left
Exchange rate
NX
ENXAD shifts to the right
ENXAD shifts to the left
Other factors that
affect exports/imports
(other than P)
NX
Factors that increase exports/decrease imports
will increase NX and AD
Factors that decrease exports/increase imports
will decrease NX and AD.
Using our summary notation we can write:
AD=C(wealth, expected-future income, taxes)+I(EFPI, government policies…, MS)+G+NX(E, other).
5. Aggregate supply is the quantity of goods and services that firms choose to produce and sell at each
price level.
6. In the long run, an economy’s production of goods and services (real output) depends on its supply of
labor (Ls), capital(K), human capital (H) and natural resources (N) and on the available technology (A)used
to turn these inputs into goods and services. Because the price level does not affect these underlying
determinants of real output, the long-run aggregate supply curve is vertical, as in Figure 1. This level of
output is known as the natural rate of output (Y LR in Figure 1).
Price Level
Figure 1.
LRAS
P1
P2
YLR
Quantity of
Real Output
Shift variables for the LRAS curve:
a. Shifts Arising from Labor— Changes in the working-age population or changes in the labor-force
participation rate would change the number of workers in the economy and would therefore change
aggregate supply. For example, a sudden wave of immigration would lead to a rightward shift in the longrun aggregate supply curve. The long-run aggregate-supply curve also depends on the natural rate of
unemployment. For instance, if the government was to increase the minimum wage this would raise the
natural rate of unemployment and reduce output—a leftward shift in the long-run aggregate-supply curve.
A change in labor laws that reduce labor mobility would have the same impact on this curve.
b. Shifts Arising from Capital—An increase in the economy’s capital stock allows an economy to produce
more goods and services and therefore shifts the long-run aggregate supply curve to the right. On the other
hand, a reduction in a country’s capital stock, due perhaps to war or some natural disaster, would shift the
long-run aggregate-supply curve to the left.
c. Shifts Arising from Human Capital--Likewise for human capital. An increase in human capital, due
perhaps to a general increase in the level of education or to a general increase in the level of health, would
shift the long-run aggregate-supply to the right.
d. Shifts Arising from Natural Resources—An economy’s level of production also depends on its
natural resources, including its minerals, land, weather. For example, the opening of land for settlement in
the 19th century in the U.S. West led to a rightward shift in the long-run aggregate-supply curve. A
sustained severe drought would shift the long-run aggregate-supply curve to the left. A prolonged cutoff
of oil to a country that imports a significant amount oil would shift this curve to the left.
e. Shifts Arising Technological Knowledge—Advances in our technological knowledge alter the amount
of goods and services an economy can produce from a given set on inputs. The invention of the computer,
for example, has increased input productivity and has thus lead to a rightward shift in the long-run
aggregate-supply curve. The adoption of the assembly-line technique in certain industries has had a similar
impact. There are other events that act like changes in technology. For example, a free-trade agreement
that open up international trade, or the adoption of new forms of business organization, would shift the
long-run aggregate-supply curve to the right. Government regulations preventing the use of certain
techniques, perhaps because of environmental issues or worker-safety concerns, would result in a leftward
shift.
To summarize: Ls LRAS shifts to the right
Ls  LRAS shifts to the left
K LRAS shifts to the right
K LRAS shifts to the left
H LRAS shifts to the right
H LRAS shifts to the left
N LRAS shifts to the right
N LRAS shifts to the left
A LRAS shifts to the right
A LRAS shifts to the left
Using our summary notation: LRAS(Ls,K,H,N,A)
An increase in the money supply would increase AD. The increase in K and H would shift the LRAS curve
to the right. Without further information, we would be unable to determine the impact on P. On the other
hand, if we know that P has risen, then we can infer from this information that AD must have increased
faster than the LRAS curve. See graphs below.
P
P
LRAS1
LRAS2
LRAS1
LRAS2
P2
P1
P1
AD2
AD2
AD1
YLR1 YLR2
AD1
Quantity of
Real Output
YLR1
YLR2
Quantity of
Real Output
7. Why does the short-run aggregate-supply curve slope upwards? In other words, why should a decrease
in the price level result in a drop in real output in the short run?
a. Misperceptions Theory: Sellers base their supply decisions on the relative price of their product. The
relative price of their product depends on the price of the product they sell and the price level. If we assume
that sellers do not know all prices at all times, then an unexpected drop in the price level may cause some
sellers to mistakenly believe that the relative price of the product they sell has declined. This will lead them
to reduce output. For example, suppose ALL prices fall by 10%, so that no relative price has changed.
Sellers can readily observe that their prices have fallen by 10%, but they may not immediately perceive that
other prices have also fallen by 10%. In fact, if some sellers believe (mistakenly) that the price level has not
changed, then they will conclude (again, mistakenly) that their relative price has declined by 10%.
b. Sticky-Wage Theory—This theory claims that the nominal wage rate (W) is slow to adjust, or is
“sticky”, in the short run. For example, suppose a long-term contract fixes the nominal wage for a nontrivial period of time. If the price level now unexpectedly declines, the real wage rate (defined as W/P) will
rise. The rise in the cost of hiring labor will reduce the quantity of labor demanded. As a consequence,
employment and real output decrease.
c. Sticky-Price Theory--- Suppose firms set price at the beginning of each period in anticipation of a certain
level of demand for their product. Once price is set, it is costly to change. The costs of changing prices are
called menu costs (“costly to print up new menu”). Assume now, due perhaps to an unexpected decline in
the money supply, that firms discover that demand for their product is lower than anticipated. In the longrun, of course, this will simply lead to a decline in the price level with no change in real output. In the
short run, however, some firms may not immediately adjust their prices due to menu costs. As a
consequence, these firms will experience a drop in sales and production.
What is the significance of an upward-slopping short-run aggregate-supply curve?
It is important to understand the significance of the upward slopping short-run aggregate-supply curve. If
the short-run aggregate-supply curve was vertical, then shifts in the aggregate demand curve would have no
impact on real output in the short run. This would mean that changes in such variables as the money supply,
government spending, or consumer confidence would be unable to explain short-run fluctuations in
economic activity, such as recessions. Instead, only shifts in the aggregate supply curve could explain these
short-run fluctuations. On the other hand, if the short-run aggregate-supply curve has a positive slope,
then unexpected shifts in aggregate demand would indeed lead to short-run fluctuations in real output.
What factors shift the short-run aggregate-supply curve? The same variables that shift the long-run
aggregate-supply curve also shift the short-run aggregate- supply curve. So changes in labor supply, capital,
human capital, natural resources and technological knowledge would all shift the short-run curve. In
addition to these shift variables, a change in the expected price level also shifts the short-run aggregatesupply curve. To understand why, it is important to recall that all of the three theories that we discussed in
class to explain the positive slope of the short-run aggregate supply curve relied upon unexpected changes
in the price level to justify this type of slope. To understand why the expected price level shifts the SRAS
curve see the answer to question 8.
8. Use Y = 2000+ (P-PE) to generate numbers in table.
For table 1, Y = 2000+(P-100)
At P=120, Y = 2000+(120-100)=2020. At P=100, Y = 2000+(100-100)=2000. At P=80, Y=2000+(80100)= 1980. For table 2, we use Y= 2000+(P-80). At P=100, Y=2000+(100-80)=2020.
At P=80, Y=2000+(80-80)=2000. At P=60, Y=2000+(60-80)=1980.
Table 1 (Expected P=100)
Actual P
Y .
120
2020
100
2000
80
1980
Table 2 (Expected P = 80)
Actual P
Y .
100
2020
80
2000
60
1980
Actual P
LRAS
120
SRAS (when expected P = 100)
100
SRAS (when expected P =80)
80
60
1980
2000
2020
Quantity of Real Output (Y)
As can be seen from the above graph, a change in PE results in the SRAS curve shifting.
9. a. Suppose there is an unexpected drop in the money supply. Since the decrease is unanticipated, there is
no change in PE and therefore no shift in the SRAS curve. The drop in money supply causes AD to
decrease. The result in the SR is a drop in P and Y.
b. Assume that consumer wealth unexpectedly rises. Again,since the increase is unanticipated, there is no
change in PE and therefore no shift in the SRAS curve. The increase wealth causes AD to increase. The
result in the SR is an increase in P and Y.
c. Assume that there is a perfectly anticipated increase in G. Since the change in G is perfectly anticipated,
there will be an increase in PE. This causes the SRAS curve to shift to the left (or up in vertical direction).
The increase in G itself causes AD to increase. There will be no impact on Y, but P increases.
d. New and costly government regulations are imposed on producers. The regulations are temporary.
This acts as a decrease in A. Since the regulations are temporary, the LRAS does not shift, but the SRAS
does decrease (shifts to the left). The result is a higher P and a lower Y.
9a.
9b.
Price Level
Price Level
LRAS
LRAS
SRAS
SRAS
PSR
P1
PSR
P1
AD2
AD1
AD1
AD2
YSR
Y1
Quantity of
Real Output
Y1
YSR
Quantity of
Real Output
9d.
LRAS
Price Level
Price Level
9c.
LRAS
SRAS2
PSR
SRAS1
P1
SRAS2
P2
SRAS1
P1
AD2
AD 1
AD
YSR
Y1
10.Answers to multiple choice questions:
10a.- b.
10b.-a.
10c.-c.
10d.-d.
10e-c.
10f-d.
10g-c.
10h-d.
10i-d.
Quantity of
Real Output
Y1
Quantity of
Real Output