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Chapter 8
Aggregate Demand, Aggregate Supply,
and the Great Depression

Chapter Outline
8-1 Combining Aggregate Demand with Aggregate Supply
8-2 Flexible Prices and the AD Curve
a. Effect of Changing Prices on the LM Curve
8-3 Shifting the Aggregate Demand Curve with Monetary and Fiscal Policy
a. Effects of a Change in the Nominal Money Supply
b. Effects of a Change in Autonomous Spending
Global Economic Crisis Focus: The Crisis was a Demand Problem Not Involving Supply
Box: Learning About Diagrams: The AD Curve
8-4 Alternative Shapes of the Short-Run Aggregate Supply Curve
8-5 The Short-Run Aggregate Supply (SAS) Curve When the Nominal Wage Rate Is Constant
a. What Is Held Constant Along the SAS Curve?
Box: Learning About Diagrams: The SAS Curve
8-6 Fiscal and Monetary Expansion in the Short and Long Run
a. Initial Short-Run Effect of a Fiscal Expansion
b. The Rising Nominal Wage Rate and the Arrival at Long-Run Equilibrium
c. The Long-Run Aggregate Supply Curve
d. Short-Run and Long-Run Equilibrium
e. Interpretations of the Business Cycle
8-7 Classical Macroeconomics: The Quantity Theory of Money and the Self-Correcting Economy
a. The Quantity Equation and the Quantity Theory of Money
b. Self-Correction in the Aggregate Demand–Supply Model
c. Classical View of Unemployment and Output Fluctuations
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8-8 The Keynesian Revolution: The Failure of Self-Correction
a. Monetary Impotence and the Failure of Self-Correction in Extreme Cases
Global Economic Crisis Focus: The Zero Lower Bound as Another Source of Monetary
Impotence
b. Fiscal Policy and the Real Balance Effect
c. Nominal Wage Rigidity
8-9 Case Study: What Caused the Great Depression?
a. Dimensions of Great Recession and Great Depression
b. Behavior of Output, Unemployment, and Other Variables in the Greta Depression
c. Explanation of Weak Aggregate Demand
d. Prices and Output Ratio in Greta Depression
IP Box: Why Was the Great Depression Worse in the United States than in Europe?
Summary

Chapter Overview
Chapter 8 develops the aggregate demand and aggregate supply curves. It extends the IS-LM model
of Chapters 3 through 6 by making the price level an endogenous variable. First, Gordon derives
the aggregate demand curve by showing how the price level affects equilibrium output via the ISLM model. Second, the causes of shifts in the aggregate demand curve are explained in detail.
Then, the aggregate supply curve is derived from an analysis of firms’ demand for labor and the
aggregate production function in which firms’ choice of employment level determines how much
real GDP can be produced. Next, these two ideas are combined to examine the short- and long-run
effects of fiscal and monetary expansion on the equilibrium level of prices, output, and the nominal
and real wage rate. After a review of the classical model of the self-correcting economy, the
Keynesian critique of self-correction is examined and an in-depth look at the Great Depression
provides data to compare the classical and Keynesian views. The chapter ends with the comparison
between the Great Depression of the 1930s and the Global Economic Crisis of 2007–10. Introduce
the chapter by explaining that the standard IS-LM model extends the simple income-determination
model by making interest rate an endogenous variable, but keeping price level as fixed. In this
chapter, the aggregate demand and aggregate supply framework will extend the IS-LM model by
making the price level also an endogenous variable. In the fixed price model, note that the IS and
LM curves previously developed are in real terms. As price becomes endogenous, change in price
level also shifts in the LM curve resulted from changes in the real money supply (M/P). Therefore,
equilibrium real GDP will be affected by either a change in the nominal money supply or the price
level. Using Figure 8-1, explain that the aggregate demand (AD) curve slopes downward simply
because lower prices will stimulate equilibrium output by increasing the real money supply. When
first confronting the AD curve, students will often confuse this concept with the traditional
downward-sloping demand curve in microeconomics. Explain that the aggregate demand curve is
not a relationship between price paid and quantity demanded by an individual consumer; rather it
plots the combinations of price and output that are consistent with the simultaneous equilibrium of
the commodity market and money market.
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Distinguishing AD shifts from movements along the AD curve is illustrated in Figures 8-2 and 8-3.
Note that non-price factors, such as monetary and fiscal policy, shift the AD curve. Movements
along the curve are due to price changes. Have students trace a price-level change and a change in
the real money supply to a shift in the LM curve and, hence, to a change in equilibrium income
along a given AD curve. Students should also trace changes in the nominal money supply and in
autonomous planned spending to shifts in the IS and LM curves, respectively, and thus to shifts in
the AD curve. Thus, they see how such changes lead to changes in the equilibrium level of income.
By working through this process, the student gets a much better feel for how the AD curve is
constructed. The price level affects equilibrium income through real balances. The amount by
which output changes depends on the slopes of both the IS and LM curves. Thus, these slopes
determine the slope of the aggregate demand curve. We can show this by deriving the AD curve in
Figure 8-1 with a steeper IS curve or flatter LM curve. This shows that the effectiveness of changes
in the real money supply on equilibrium income is reduced and the AD curve becomes steeper (see
Figure 8-A below). Another way of seeing this is to note that the equation of the AD curve is: Y =
k1Ap ‘+ k2(Ms/P) {Equation 9 in the appendix of chapter 4}. Thus, any factor that increases k2, the
“real money supply” multiplier, will lead to a flatter AD curve. Note that these factors determine the
effectiveness of monetary policy. This equation also helps students see what factors shift the AD
curve.
Figure 8-A
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We needed two relationships to find equilibrium real GDP and the equilibrium interest rate in the
IS-LM model. Similarly, the AD curve is not sufficient to find equilibrium real GDP and the price
level. We require another relationship, the aggregate supply curve. The importance of the short-run
aggregate supply (SAS) curve is stressed in Figure 8-4. This figure shows that the effect of an
expansion in aggregate demand on equilibrium real GDP and prices cannot be determined without
knowing the precise shape of the SAS curve.
Section 8-5 derives the SAS curve on the assumption that firms are profit maximizers and the
nominal wage rate is constant. Because the marginal product of labor declines as additional workers
are hired to work with fixed amounts of other resources, profit-maximizing firms will hire
additional workers only if the real wage rate declines. Thus, the labor demand curve is downward
sloping. It also indicates that as the price level falls and the real wage rises, firms will employ fewer
workers and thus produce less output (all other things being equal). As the price level rises, the real
wage falls and firms hire more workers and produce more output. Thus, there is a positive short-run
relationship between the price level and real GDP. The position of the SAS curve depends on the
nominal wage and the marginal product of labor. Consequently, they are both fixed for a given
short-run aggregate supply curve. Later, students will relate this to the stickiness of the nominal
wage and the existence of business cycles. This chapter focuses on the nominal wage as the factor
that shifts the SAS curve. Supply shocks and changes in the marginal product of labor are analyzed
in Chapter 9. Figure 8-5 also illustrates the effect of an increase in the nominal wage rate on the
SAS curve. With higher nominal wages, firms will hire less labor at every price level. Therefore, the
SAS curve shifts leftward to reflect a lower output level at every price level.
The analysis in Section 8-5 motivates the important distinction between the short-run and long-run
equilibrium effects of an expansion in aggregate demand in Section 8-7. Notice that Figure 8-6 is
just an extension of the right-hand frame of Figure 8-5 that combines the aggregate supply and
demand curves. The initial rise in the equilibrium income and price level is the result of a fiscal
expansion which shifts the AD curve up from AD0 to AD1 along the given SAS curve. Because the
nominal wage rate initially remains fixed and workers are off their labor supply curve, this situation
is defined to be a new short-run equilibrium (at point C from B before). When the nominal wage
raises enough to compensate workers for the price-level increase, the labor market reaches the
equilibrium real wage and the economy attains long-run equilibrium (at Point E3). Point out that the
rise in the nominal wage and resulting shift in the SAS curve will increase the price level along the
new AD curve in Figure 8-6. The long-run equilibrium price level will be much higher than the
original increase caused by the fiscal expansion. The equilibrium level of output will return to the
original long-run equilibrium level. The important point in this section is that short-run equilibrium
always occurs at the intersection of the AD and SAS curves. It will only be the long-run equilibrium
point when the actual and equilibrium real wages are equal. Also note that if the equilibrium wage
rate remains unchanged, the long-run level of output, or the natural level of GDP, will remain
unchanged as well (vertical long-run aggregate supply curve.)
Section 8-6 concludes with a brief discussion of the implications of the aggregate demand and
supply model for the interpretation of business cycles. As a motivation for Sections 8-7 and 8-8, as
well as for Chapter 9, point out that if the actual real wage returns to its equilibrium levels
immediately, the output expansion will be short and transitory and the movement of the real wage
will be countercyclical. However, U.S. business cycles have persisted for years. Thus, we must
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develop theoretical models that will determine the speed at which the economy adjusts to its
long-run equilibrium output level. This topic is introduced in Sections 8-7and 8-8 and more fully
developed in Chapter 9.
Section 8-8 includes a discussion of the quantity theory of money and the “self-correcting
economy” as a summary of the views of the pre-Keynesian classical economists. The classical
theory is presented graphically in Figure 8-7. This presentation contains a complementary
discussion of the famous classical quantity equation and the quantity theory of money. Figure 8-7
shows the implications of the classical assumption of perfectly flexible prices. Any deviation of
actual real GDP from natural real GDP (then called “full employment” real GDP) caused by an
aggregate-demand shift would be very brief, for prices would automatically adjust. This arises from
the assumption that a decline (leftward shift from AD0 to AD1) in aggregate demand induces firms
to lower prices and wages in response to the excess supply. Thus, aggregate demand is stimulated,
and the economy moves along the new AD1 curve until the natural level of output is restored. To
show the relationship between the quantity equation and the AD curves in Figure 8-6 point out that
the quantity equation can be rewritten Y = M s V/P. Stress again that the quantity equation is an
identity. The classical quantity theory of money specified that, given perfectly flexible prices and
constant velocity, a change in M s results in an equiproportional change in P. Thus, aggregate
demand shifts down from AD0 to AD1 with no change in the level of output. Be sure students
understand that velocity changes in response to shifts in the IS curve and LM curve. Also point out
that changes in velocity can cause the LM and AD curves to shift in the same way that changes in
the nominal money supply shifts these curves. Thus, changes in autonomous planned expenditures,
through changing V, will also lead to the same classical result of an equiproportional change in
prices so that equilibrium output remains unchanged. Figure 8-B below illustrates the cases of a
monetary contraction and a decline in autonomous planned spending. The important implication of
the classical model is that, because prices are perfectly flexible, the economy will always
automatically adjust to the natural level of employment, and no fiscal intervention is needed. The
section on the classical model concludes with the views of the classical economists about
unemployment and output fluctuations.
The publication of J.M. Keynes’ General Theory of Employment, Interest, and Money brought
about the “Keynesian Revolution.” The Keynesian critique of the classical self-correcting
mechanism is presented in Section 8-8, and it is divided into two categories: the failure of demand
to adjust because of monetary impotence, inadequate effect of fiscal policy and the failure of supply
to adjust because of rigid nominal wages. On the demand side, explain that the classical model with
perfectly flexible prices relies on two important mechanisms by which a deflation leads to a
stimulation of output to its natural level. First, a deflation has to lower interest rates through
increasing real balances (M/P); and second, interest rates must be lowered enough to stimulate the
autonomous planned spending and aggregate demand necessary to bring the output level back to its
natural level. Keynes’ objection to the first channel is the liquidity trap. A liquidity trap is a
condition in which an extremely low interest rate causes people to hold any additional money
instead of purchasing interest-bearing assets. Thus, the LM schedule is horizontal, and increases in
the real money supply will not shift the LM curve. Then, interest rates and thus output will not
respond to the increase in the real money supply resulting from the deflation. Gordon also points
out that “Zero lower bound” or the fact that nominal interest rate cannot be negative may also lead
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to impotence of monetary policy (note the Box: Global Economic Crisis Focus). Keynes’ objection
to the second channel is the possibility that autonomous planned expenditures are very or totally
Figure 8-B
unresponsive to changes in the interest rate. This implies a very steep or vertical IS curve and AD
curve so that output will not respond to the deflation (Figure 8-8). According to Gordon, the
evidence is more consistent with the interpretation that the IS Curve was vertical than that the LM
curve was horizontal. Both demand-side problems result from the failure of flexible prices to
influence real output through the real money supply. Hence, they are called the problem of
“monetary” or “deflationary” impotence. The classical economists responded to the Keynesian
criticism of deflationary impotence. Their argument relied on the Pigou or real balance effect. This
effect occurs when the increase in real money balances caused by a deflation stimulates
autonomous planned spending directly. The force of the real balance effect is countered, however,
by the possibility of destabilizing expectations and redistribution effects of falling prices.
We turn now to the second Keynesian critique of the classical model. It is that nominal wage
rigidity implies failure of the aggregate supply curve to adjust. Figure 8-9 graph shows the
implications of the Keynesian rigid-wage assumption. A fall in aggregate demand (caused by a
decline in planned spending) along a given aggregate supply curve causes a fall in the price level
and a rise in the real wage. In the Keynesian model, nominal wage rigidity keeps workers off their
labor supply curve because it prevents adjustment of the actual wage to its equilibrium, or
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market-clearing value. This, in turn, prevents the shifts in the SAS curve necessary to return the
economy to its natural level of output. The Keynesian model explains the persistence of
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unemployment arising from nominal wage rigidity. Its drawbacks include a failure to explain why
or how the nominal wage remains rigid and the requirement that real wages move countercyclically. Section 8-8 concludes by making the distinction between market-clearing and non
market-clearing models. These concepts provide the basic theme for the modern business-cycle
theories that are covered in Chapter 17.
Section 8-9 provides a case study of the causes of the Great Depression. Figure 8-10 and Table 8-1
provide support for the Keynesian view that it was interest-insensitive autonomous planned
investment, instead of a liquidity trap, that contributed to the failure of the classical self-correcting
mechanism. The data on nominal wages in Table 8-1 provide further support for the Keynesian
model. They show that the nominal wage was quite rigid and that, instead of falling, the real wage
rose during the Great Depression. Gordon also examines the role of domestic and international
monetary policy in causing the severity of the Great Depression, and he also looks at policy failures
of the Roosevelt Administration. In an IP Box, Gordon examines why the Great Depression was
more severe in the United States than in Europe. Gordon also compares the dimensions of the Great
Depression with the recent Great Recession of 2007–09. In Figure 8-10 he shows that loss of output
in Great Recession is much smaller when compared with the Great Depression.
In teaching the material in Chapter 8, remind the student that this is a static model of the
equilibrium price and output level. It does not explain the determination of the equilibrium inflation
rate and the transitional path that the economy follows in reaching the long-run rate of inflation and
output. These are the topics of Chapter 9.

Changes in the Twelfth Edition
This chapter is essentially Chapter 7 of the last edition. The structure and content remain largely
unchanged from the 11th edition although it has gone through moderate changes. The introductory
explanation of this chapter has been eliminated in the new edition. Discussion regarding labor
demand curve and labor supply curve in Section 8-5 has been deleted. Consequently discussion
about SAS curve and Figure 8-5 has been modified and Figure 7-7 has been deleted. The Box:
“Learning About Diagrams: The SAS Curve” has been modified. The subsection with the title
“How Wage Rate Is Set” has been deleted. Gordon has added a new box about “Global Economic
Crisis Focus” in Section 8-8. Figure In the case study “What Caused the Great Depression?” figures
depicting the Great Depression have been extended to include the experience of the Great
Recession of 2007–09.
Summary section has been modified. Question and Problems sections have also been reorganized
with new questions.

Answers to Questions in the Textbook
1. In microeconomics, the demand curve shows the various quantities of a specific product that a
consumer wants at various prices for that product, holding preferences, income, and other prices
constant. The quantity demanded changes because of a change in relative prices. In macroeconomics,
the AD curve shows the various quantities of GDP demanded at various price levels in the economy.
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Here, there is no change in relative prices of other products (although if the nominal wage is
unchanged, there is a change in the real wage, which is a relative price). In macroeconomics, the
increase in output demanded arises because the changing price level causes the real money supply (and
interest rates) to change.
2. a. The AD curve is steeper when the interest responsiveness of the demand for money becomes larger.
When the interest responsiveness of the demand for money becomes larger, the demand for money
curve will have a flatter slope relative to the M/P axis. A given increase in the real money supply
will therefore produce less of a reduction in the interest rate, less of an expansion in autonomous
planned spending, and less of an expansion in real GDP. Consequently, a given reduction in the
price level, which increases the real money supply, will have a smaller effect on real GDP when the
interest responsiveness of the demand for money is larger.
b. The AD curve is flatter when the income responsiveness of the demand for money is larger because
the LM curve is steeper. A steep LM curve amplifies the effect on output of a higher real money
supply, all other things held equal.
3. a. Shifts the LM curve to the right; therefore, AD curve shifts to the right.
b. An increase in foreign income shifts the aggregate demand to the right. The rise in foreign income
causes exports and therefore net exports to increase at each level of income and interest rate in this
country, that is, autonomous planned spending rises. That increase will cause firms to expand
output, resulting in a rise in real GDP at each interest rate. The increase in real GDP at each interest
rate shifts the IS curve to the right and causes a movement up the LM curve. Therefore, there is an
increase in aggregate demand at every price level, which is represented graphically as a shift to the
right of the aggregate demand curve.
c. An increase in the income tax rate increases the size of the marginal leakage rate, which reduces
the size of the multiplier. That shifts the horizontal intercept of the IS curve left, but does not
change its vertical intercept. Therefore the IS curve is steeper and the new IS curve is to the left of
the original IS curve. Therefore at any given price level, the LM curve intersects the new IS curve at
a lower level of income, which shifts the AD curve left. However, a shift of the LM curve left
because of a higher price level reduces income less since the new IS curve is steeper, which results
in a steeper AD curve.
d. Shifts the vertical intercept of the IS curve down and makes the IS curve flatter; the effect on
horizontal intercept is ambiguous. Nevertheless, the AD curve shifts to the right and becomes
flatter. For the AD curve, it can be shown that ΔY/Δc > 0 if Y > Ta + tY.
e. Makes the IS curve pivot upward about its horizontal intercept, kAp , because the vertical intercept,
Ap /b, becomes larger as b becomes smaller. Therefore, the AD curve shifts to the right and
becomes steeper.
f. Leaves the original IS curve unchanged (absent a real balance effect), but shifts the LM curve to the
left by decreasing the real money supply. Because the nominal money supply has not changed,
however, this causes a movement along the original AD curve, rather than a shift in it.
g. Makes the IS curve shift to the right; therefore, the AD curve shifts to the right.
h. Makes net exports increase, thus shifting the IS curve to the right; therefore, the AD curve shifts to
the right.
i Makes the IS curve shift to right: therefore, the AD curve shifts to the right.
j. Makes the IS curve shift to left: therefore, the AD curve shifts to the left.
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4. The assumption of a fixed nominal wage means that labor costs remain fixed as firms increase output.
Therefore profits increase as firms expand output when the prices of goods and services sold by
businesses rise, which is why the aggregate supply curve is upward sloping.
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5. a. Increases.
b. No change.
c. Decreases.
6. A higher price level results in higher profits for firms if they expand the amount of goods and services,
given that input costs are fixed. That is why real GDP increases as the price level rises.
7. Nominal wages adjust slowly for three reasons. First, formal or informal contract fix wages for a
period of time, just as union contracts or the contracts professional athletes sign for one or more
seasons. Second, in the absence of formal labor contracts, it takes time for workers and managers to
evaluate how productive workers are in order to determine what the workers should be paid, so that in
the period between performance evaluations, the nominal wages of workers are fixed. Finally
businesses are reluctant to reduce nominal wages out of the fear of losing their best employees.
8. a. Technological improvements increase profits. Higher profits cause firms to produce more, given
nominal wages and other input prices. Since output is greater at each price level, the SAS curve
shifts to the right.
b. The decrease in the nominal wage rate lowers costs and increase profits at each price level,
resulting in an increase in output. Since output increases at each price level, the SAS curve shifts to
the right.
c. Lower prices for raw materials reduce costs and increase profits at each price level, resulting in an
increase in output. Since output increases at each price level, the SAS curve shifts to the right.
9. The increase in aggregate demand would cause the price level, output, and the interest rate to rise. The
interest rate rises not only because the increased spending shifts the IS curve right but the higher price
level shifts the LM curve left. That increase in the interest rate crowds out autonomous consumption
spending and autonomous investment. With flexible exchange rates, an increase in the interest rate will
cause the exchange rate to increase and there will also be a crowding out effect on net exports and in
addition imports rise as income rises. The increase in government spending is likely to increase the
budget deficit, although not as much as the rise in spending since the higher level of income generates
more tax revenue.
10. a. Real output decreases and interest rate increases via the IS-LM analysis. Thus, AD curve shifts to
the left along the SAS curve. So the price level also declines. Thus, both output and the price level
decline in the short run. The lower price level also reduces firms’ profits and causes them to try to
reduce costs. Since a lower price level has increased the real wages of workers, they are likely to
agree to reductions in nominal wages. Lower nominal wages shift the SAS curve right, which leads
to an additional drop in the price level. That lower price level increases the real money supply,
shifting the LM curve to the right. The shift to the right of the LM curve is represented as a
movement down the new AD curve. The nominal wage and the price level continue to decline and
output continues to rise until the output returns to its original level and the IS and LM curves
intersect at the original level of output. In the long run, output and employment and real wage do
not change. However, the price level and the nominal wage both decline.
b. Output and the interest rate both increase when net exports rise as a result of the depreciation in the
dollar. The increase in output and the rise in the interest rate are shown graphically as a shift right
of the IS curve and a movement up the LM curve. The AD curve shifts right by the amount that
income increases at the intersection of the new IS curve and the LM curve. The price level rises
since aggregate demand exceeds aggregate supply at the initial price level. The rise in the price
level is shown graphically as movements up the SAS curve and the new aggregate demand curve.
The rise in the price level reduces the real money supply, which is shown as a shift left of the LM
curve and corresponds to the movement up the new aggregate demand curve. Therefore output, the
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interest rate, and the price level all increase in the short run, while the real wage rate falls due to the
rise in the price level.
Once workers notice that their real wages have fallen, they will seek higher nominal wages. The
rise in the nominal wage rate shifts the SAS curve to the left, which results in a further rise in the
price level but a decline in output which is shown graphically as a movement up the new AD curve.
Corresponding to this movement up the new AD curve is a shift left of the LM curve as the
additional increase in the price level leads to a further decline in the real money supply. The
interest rate continues to rise as the real money supply continues to decline. The price level, the
interest rate, and the nominal and real wage rates all continue to increase and output continues to
decline as the SAS and LM curves continue to shift left until the SAS curve, the new AD curve, and
the LAS curve all intersect at the original level of real output, YN. So at the new long-run
equilibrium, the effect of the depreciation of the dollar is a higher price level, a higher nominal
wage, and a higher interest rate, but no change in the equilibrium real wage rate or real GDP.
11. No. The economy is in short-run equilibrium when the AD and SAS curves intersect, but not
necessarily in long-run equilibrium. It will be a sustainable long-run equilibrium only the price level
and the nominal wage are such that the real wage rate equals the equilibrium real wage and Y = YN. At
any other combination of W, P, and Y, the SAS curve will shift as the nominal wages adjust.
12. The movement down the AD curve would result from falling prices in response to the economy’s being
below YN. The parameter for the SAS curve is the nominal wage rate. If the SAS curve did not shift
(nominal wages did not fall), the falling price levels would yield real wages above the equilibrium real
wage. Thus, nominal wages must fall along with prices if the economy is going to “self-correct.”
During the Great Depression, nominal wages did not behave as the classical economists predicted:
nominal wages did not decline continuously during the 1930s when Y was below YN; in fact, in 1937
the nominal wage rate was back to the 1929 level, despite an unemployment rate of 14.3 percent.
13. Monetary impotence refers to the situation when an increase in the real money supply does not
stimulate additional spending and output. The two conditions that would lead to monetary impotence
are a vertical IS curve or horizontal LM curve. Because of falling consumer and business confidence,
the IS curve during the depression was very steep. This suggests that changes in the interest rate would
have had very little effect on desired spending.
14. A zero lower bound on the interest rate prevents a falling price level, which increase the real money
supply, from reducing the nominal interest rates below zero. In fact, once the zero lower bond is
reached lower bound falling prices raise the real interest rate since the inflation rate is negative and the
nominal interest rate cannot fall further.
15. Unlike the United States, Britain allowed its foreign exchange to fall, resulting in a rise in net exports
and a relatively smaller decrease in aggregate demand. That relatively smaller decrease in aggregate
demand resulted in a less severe downturn in output in the United Kingdom than in the United States.
The German government’s spending on armaments, highways, and housing resulted in a more
expansionary fiscal policy than the one pursued by the U.S. government and a relatively smaller
decrease in aggregate demand in Germany than in the United States. In addition, the German
government allowed prices and wages to fall, unlike the U.S. government which took actions to raise
wages and prices. Thus, the actions of the German government allowed its economy’s SAS curve to
shift right, whereas the actions of the U.S. government caused the American economy’s SAS curve to
shift left. Therefore, governmental policies toward wages and prices moderated the severity of the
Great Depression in Germany, whereas they exacerbated it in the United States.
16. The interest rate does not play any role in the Pigou Effect.
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17. A fall in prices, with a constant nominal money supply, leads to an increase in the real money supply.
With the Pigou Effect, this increase in the money supply will directly affect the demand for
commodities; thus, the AD curve cannot be vertical.
18. In a period of continuing inflation, the value of real balances would decline if the growth rate of the
nominal money supply was less than the inflation rate. This change in wealth might cause a decline in
autonomous expenditures, thus helping to slow the growth rate of output. Here, the expectations effect
might work against policymakers if people, expecting further inflation, decide to “buy today” and beat
the price increases. This activity would stimulate spending. Similarly, the redistribution effect could
work against policymakers if the winners from the inflation tended to spend at a greater rate than
losers.
19. The initial impact of the increase in autonomous exports will be to shift both the IS and AD curves to
the right. Both output and prices would increase. Given the existence of a real balance effect, however,
the rising prices will cause the IS curve to shift backward to the left along the (assumed) constant LM
curve. This implies a movement upward along the new AD curve. The economy will return
automatically to the intersection with the LAS line. If the expectations and redistribution effects are
present, then these will shift the AD curve to the right, exacerbating the rise in prices accompanying
the increase in autonomous exports.
20. If the nominal wage is rigid downward, the SAS curve will remain fixed. Even if the AD curve is
downward sloping, the price level can fall along the AD curve only until the AD curve intersects the
fixed SAS curve. As a result, a shift to the left by the AD curve will result in an output level below YN
and real wages above the equilibrium level.
21. The decline in the output ratio in the United States during the Great Depression was much larger, from
more than 100 percent in mid-1929 to 61 percent by late 1932, than it was during the Global Economic
Crisis, when the output ratio declined by “only” 8 percentage points from late 2007 to mid-2009.
22. The 1929 stock market collapse reduced real wealth, thereby reducing consumption expenditures, just
as the collapse of housing and stock prices did in the United States just prior to and during the Global
Economic Crisis. Similar to the pattern in the United States from 2001–10, over construction of houses
and commercial real estate during the 1920s contributed to a sharp decline in fixed investment
spending during the Great Depression. However, there was an important difference between what
caused the decline in aggregate demand during the Great Depression and what happened during the
Global Economic Crisis that was the behavior of the money supply. The Fed allowed the nominal
money supply to decline by 25 percent between 1929 and 1933 and allowed many banks to fail; the
behavior of the Fed was drastically different during the Global Economic Crisis.

Answers to Problems in Textbook
1. a. Given that Ap equals 5,000 and Ms equals 2,000, the equation for aggregate demand is
Y = 1.25(5,000) + 2.5(2,000/P) = 6,250 + 5,000/P. Aggregate demand equals 6,250 + 5,000/2 =
8,750 when the price level equals 2. Aggregate demand equals 6,250 + 5,000/1.25 = 10,250 when
the price level equals 1.25. Aggregate demand equals 6,250 + 5,000/1 = 11,250 when the price level
equals 1. Aggregate demand equals 6,250 + 5,000/.8 = 12,500 when the price level equals .8, and it
equals 6,250 + 5,000/.5 = 16,250 when the price level equals .5. The points on the aggregate
demand curve are: (16,250, 0.5); (12,500, 0.8); (11,250, 1.0); (10,250, 1.25); and (8,750, 2.0).
b. Given that the nominal wage rate equals 50, the equation for the short-run aggregate supply curve is
Y = 11,250 – 20(50) + 1,000P = 10,250 + 1,000P. The amount of short-run aggregate supply when
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the price level equals 2 is 10,250 + 1,000(2) = 12,250. The amount of short-run aggregate supply
when the price level equals 1.25 is 10,250 + 1,000(1.25) = 11,500. The amount of short-run
aggregate supply when the price level equals 1 is 10,250 + 1,000(1) = 11,250. The amount of shortrun aggregate supply when the price level equals .8 is 10,250 + 1,000(.8) = 11,050, and it equals
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Answers to Problems in Textbook
96
10,250 + 1,000(.5) = 10,750 when the price level equals .5. The points on the short-run aggregate
supply curve are: (10,750, 0.5); (11,050, 0.8); (11,250, 1.0); (11,500, 1.25); and (12,250, 2.0).
c. The short-run equilibrium values of real GDP and the price level are where aggregate demand and
short-run aggregate supply are equal, which is the point of intersection of the aggregate demand
curve and the short-run aggregate supply curve. The point of intersection occurs when real GDP
equals 11,250 and the price level equals 1.0.
The long-run equilibrium values of real GDP and the price level are where aggregate demand and
long-run aggregate supply are equal. Since the long-run aggregate supply curve is vertical at natural
real GDP and since natural real GDP equals 11,250, the long-run equilibrium values of real GDP
and the price level are also 11,250 and 1.0.
d. The equilibrium real wage rate occurs at natural real GDP. Since the nominal wage rate equals 50
and the price level equals 1.0 at natural real GDP, the equilibrium real wage rate equals
50/1.0 = 50.
e. The increase in planned spending is caused by an increased willingness of financial market firms to
lend to households and businesses, which results in a rise in autonomous consumption and planned
investment expenditures at every level of income and interest rate, that is, autonomous planned
spending rises.
The new equation for aggregate demand is Y = 1.25(5,800) + 2.5(2,000/P) = 7,250 + 5,000/P.
Aggregate demand now equals 7,250 + 5,000/2 = 9,750 when the price level equals 2. Aggregate
demand now equals 7,250 + 5,000/1.25 = 11,250 when the price level equals 1.25. Aggregate
demand now equals 7,250 + 5,000/1 = 12,250 when the price level equals 1. Aggregate demand
now equals 7,250 + 5,000/.8 = 13,500 when the price level equals .8, and it now equals 7,250 +
5,000/.5 = 17,250 when the price level equals .5. The points on the new aggregate demand curve
are: (17,250, 0.5); (13,500, 0.8); (12,250, 1.0); (11,250, 1.25); and (9,750, 2.0).
f. The new short-run equilibrium values of real GDP and the price level are where aggregate demand
and short-run aggregate supply are equal, which is the point of intersection of the new aggregate
demand curve and the short-run aggregate supply curve. The point of intersection occurs at real
GDP approximately equal to 11,450 and the price level approximately equal to 1.2. If you set the
new equation of the aggregate demand curve equal to the equation of the short-run aggregate
supply curve and solved for the value of the price level, then you find that the short- run
equilibrium value of the price level equals 1.19258, and the short-run equilibrium value of real
GDP equals 11,442.58.
g. The long-run equilibrium values of real GDP and the price level are where new aggregate demand
and long-run aggregate supply are equal. Since the long-run aggregate supply curve is vertical at
natural real GDP and since natural real GDP equals 11,250, the long-run equilibrium value of real
GDP is 11,250. The new aggregate demand curve intersects the long-run aggregate supply curve at
a price level equal to 1.25, which is the new long-run equilibrium price level.
Given that the price level rises from 1.0 to approximately 1.2 in the short-run when aggregate
demand increases, then the real wage rate falls from 50 to approximately 50/1.2 = 41.67, given no
change in the nominal wage rate. The decline in the real wage rate drives it below the equilibrium
real wage rate. That causes the nominal wage rate to rise as workers and firms negotiate new
contracts. The rise in the nominal wage shifts the short-run aggregate supply curve left, resulting in
a further rise in the price level and a drop in real GDP. The nominal wage rate and the price level
continue to rise, while real GDP continues to fall until the real wage rate equals the equilibrium
real wage rate, which occurs when the new aggregate demand curve, a short-run aggregate supply
curve, and the long-run aggregate supply curve all intersect at natural real GDP.
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Since the real wage rate must equal 50, the equilibrium real wage rate, when the economy is at
long-run equilibrium, the nominal wage rate, W, must be such that W/1.25 = 50. Therefore, the new
nominal wage rate equals 62.50, given that the new long-run equilibrium price level equals 1.25.
Therefore, the new short-run aggregate supply curve is Y = 11,250 – 20(62.50) + 1,000P
= 10,000 + 1,000P.
h. If fiscal policymakers want to prevent a rise in the price level when the financial market firms are
more willing to lend to households and businesses, they would have to cut spending enough or
increase taxes enough to exactly offset the rise in planned spending that results from the increase in
autonomous consumption and planned investment expenditures. That would require them to take
steps that reduce planned spending by 800 billion if they want to prevent a rise in the price level
that would otherwise occur as a result of the fall in the exchange rate.
If monetary policymakers want to prevent a rise in the price level when households and businesses
can borrow more easily, they would have reduce the nominal money supply enough to keep
aggregate demand equal to 11,250 at a price level equal to 1.0, given the increase in autonomous
planned spending. This requires that 11,250 = 1.25(5,800) + 2.5(Ms'/1.0), where M s' is that value of
the nominal money supply that prevents a rise in the price level. Therefore, 11,250 = 7,250 + 2.5M
s
' or 4,000/2.5 = 1,600 = M s'. Therefore, monetary policy makers must cut the nominal money
supply by 400 billion from 2,000 to 1,600 to prevent a rise in the price level that would otherwise
occur as a result of the increased amount of autonomous consumption and planned investment
expenditures.
2. a. The decrease in planned spending is caused by a collapse in the housing market. The reduction in
household wealth and housing construction causes autonomous consumption and planned
investment expenditure to fall. Therefore, autonomous planned spending declines.
The new equation for aggregate demand is Y = 1.25(4,000) + 2.5(2,000/P) = 5,000 + 5,000/P.
Aggregate demand now equals 5,000 + 5,000/2 = 7,500 when the price level equals 2. Aggregate
demand now equals 5,000 + 5,000/1.25 = 9,000 when the price level equals 1.25. Aggregate
demand now equals 5,000 + 5,000/1 = 10,000 when the price level equals 1. Aggregate demand
now equals 5,000 + 5,000/.8 = 11,250 when the price level equals .8, and it now equals 5,000 +
5,000/.5 = 15,000 when the price level equals .5. The points on the new aggregate demand curve
are: (15,000, 0.5); (11,250, 0.8); (10,000, 1.0); (9,000, 1.25); and (7,500, 2.0).
b. The new short-run equilibrium values of real GDP and the price level are where aggregate demand
and short-run aggregate supply are equal, which is the point of intersection of the new aggregate
demand curve and the short-run aggregate supply curve. The point of intersection occurs at real
GDP approximately equal to 11,075 and the price level approximately equal to .825. If you set the
new equation of the aggregate demand curve equal to the equation of the short-run aggregate
supply curve and solved for the value of the price level, then you find that the short-run equilibrium
value of the price level equals .82328, and the short-run equilibrium value of real GDP equals
11,073.28.
c. The long-run equilibrium values of real GDP and the price level are where new aggregate demand
and long-run aggregate supply are equal. Since the long-run aggregate supply curve is vertical at
natural real GDP and since natural real GDP equals 11,250, the long-run equilibrium value of real
GDP is 11,250. The new aggregate demand curve intersects the long-run aggregate supply curve at
a price level equal to .8, which is the new long-run equilibrium price level.
Given that the price level falls from 1.0 to approximately .825 in the short run when aggregate
demand decreases, then the real wage rate rises from 50 to approximately 50/.825 = 60.61, given no
change in the nominal wage rate. The rise in the real wage rate drives it above the equilibrium real
wage rate. That causes the nominal wage rate to fall as workers and firms negotiate new contracts.
The fall in the nominal wage shifts the short-run aggregate supply curve right, resulting in a further
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decline in the price level and an increase in real GDP. The nominal wage rate and the price level
continue to fall, while real GDP continues to rise until the real wage rate equals the equilibrium
real wage rate, which occurs when the new aggregate demand curve, a short-run aggregate supply
curve, and the long-run aggregate supply curve all intersect at natural real GDP.
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Since the real wage rate must equal 50, the equilibrium real wage rate, when the economy is at
long-run equilibrium, the nominal wage rate, W, must be such that W/.8 = 50. Therefore, the new
nominal wage rate equals 40, given that the new long-run equilibrium price level equals .8.
Therefore, the new short-run aggregate supply curve is Y = 11,250 – 20(40) + 1,000P = 10,450 +
1,000P.
d. If fiscal policymakers want to prevent a rise in unemployment when the housing market collapses,
they would have to increase spending enough or cut taxes enough to exactly offset the decline in
planned spending that results from the housing market collapse. That would require them to take
steps that increase planned spending by 1,000 billion if they want to prevent a rise in
unemployment that would otherwise result from the collapse of the housing market.
If monetary policymakers want a rise in unemployment when the housing market collapses, they
would have to increase the nominal money supply enough to keep aggregate demand equal to
11,250 at a price level equal to 1.0, given the drop in autonomous planned spending. This requires
that 11,250 = 1.25(4,000) + 2.5(M s˝ /1.0), where M s˝ is that value of the nominal money supply
that prevents a rise in unemployment. Therefore, 11,250 = 5,000 + 2.5 M s˝ or 6,250/2.5 = 2,500 =
M s˝. Therefore, monetary policy makers must increase the nominal money supply by 500 billion
from 2,000 to 2,500 to prevent a rise in unemployment that would otherwise occur as a result of the
collapse of the housing market.
3. a. The equation of the IS curve is Y = kAp. Therefore, the equation of the IS curve is Y = 2.5(5,200 –
200r) = 13,000 – 500r. Since the price level is 1.0, the real money supply equals 1,800/1.0.
Therefore, the equation for the LM curve is Y = 5(1,800) + 500r = 9,000 + 500r. To compute the
equilibrium interest rate, set the equation for the IS curve equal to the equation for the LM curve to
get 13,000 – 500r = 9,000 + 500r. Adding 500r to and subtracting 9,000 from both sides yields
1,000r = 4,000. Dividing both sides by 1,000 yields the equilibrium interest rate, r = 4.
To compute equilibrium real output, substitute the equilibrium interest rate into the equations
for the IS and LM curves to get Y = 13,000 – 500(4) = 9,000 + 500(4) = 11,000.
b. When the price level is 0.8, the real money supply equals 2,250. Therefore, the equation for the LM
curve is Y = 5(2,250) + 500r = 11,250 + 500r. Setting the IS and LM curves equal to each other and
solving for r and Y yields that the equilibrium real output equals 12,125 and the equilibrium interest
rate equals 1.75 percent. When the price level is 1.2, the real money supply equals 1,500.
Therefore, the equation for the LM curve is Y = 5(1,500) + 500r = 7,500 + 500r. Setting the IS and
LM curves equal to each other and solving for r and Y yields that the equilibrium real output equals
10,250 and the equilibrium interest rate equals 5.5 percent. When the price level is 2.0, the real
money supply equals 900. Therefore, the equation for the LM curve is Y = 5(900) + 500r = 4,500 +
500r. Setting the IS and LM curves equal to each other and solving for r and Y yields that the
equilibrium real output equals 8,750 and the equilibrium interest rate equals 8.5 percent.
The points on the aggregate demand curve are: (12,125, 0.8); (11,000, 1.0); (10,250, 1.2); and
(8,750, 2.0).
c. Long-run equilibrium requires the nominal wage rate and the price level at which aggregate
demand and short-run aggregate supply are equal be such that the real wage rate equals the
equilibrium real wage rate. Therefore, the long-run aggregate supply curve is vertical at natural real
output, which in this problem equals 11,000. Therefore, the long-run equilibrium real output is
11,000, the long-run equilibrium price level is 1.0, and the long-run equilibrium interest rate is 4
percent.
d. The equation of the new IS curve is Y = 2.5(5,800 – 200r) = 14,500 – 500r. Setting the equation for
the new IS curve equal to the equations for the LM curves and solving for r and Y yields that at a
price level of 0.8, the equilibrium real output equals 12,875 and the equilibrium interest rate equals
3.25 percent; at a price level of 1.0, the equilibrium real output equals 11,750 and the equilibrium
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interest rate equals 5.5 percent; at a price level of 1.2, the equilibrium real output equals 11,000 and
the equilibrium interest rate equals 7.0 percent; at a price level of 2.0, the equilibrium real output
equals 9,500 and the equilibrium interest rate equals 10.0 percent.
e.
f.
4. a.
b.
c.
The points on the new aggregate demand curve are: (12,875, 0.8); (11,750, 1.0); (11,000, 1.2); and
(9,500, 2.0).
Since aggregate demand exceeds aggregate supply at a price level of 1.0, the price level increases.
Firms increase real output as the price level rises, which is a movement up the SAS curve. The rise
in the price level also reduces the real money supply which results in a movement up the new AD
curve. The price level continues to rise until aggregate demand and short-run aggregate supply are
equal. The real wage rate falls as the price level rises, given the nominal wage rate.
The decline in the real wage rate drives it below the equilibrium real wage rate. That causes the
nominal wage rate to rise as workers and firms negotiate new contracts. The rise in the nominal
wage shifts the SAS curve left, resulting is a further rise in the price level and a drop in real output.
The nominal wage rate and the price level continue to rise, while real output continues to fall until
the real wage rate equals the equilibrium real wage rate, which occurs when the new AD curve, an
SAS curve, and the LAS curve all intersect at natural real output, which in this problem equals
11,000. The new long-run equilibrium price level is 1.2 and the new long-run equilibrium interest
rate is 7 percent as well.
See Problem 1 for the equation of the LM curve. The equation of the IS curve is Y = kAp. Therefore,
the equation of the IS curve is Y = 2.5(4,600 + 600/P – 200r) = 11,500 + 1,500/P – 500r. Since the
price level is 1.0, the equation of the IS curve is Y = 13,000 – 500r. Setting the IS and LM curves
equal to each other and solving for r and Y yields that the equilibrium real output equals 11,000 and
the equilibrium interest rate equals 4.0.
See Problem 1 for the equations of the LM curves. When the price level is 0.8, the equation of the
IS curve is Y = 11,500 + 1,500/0.8 – 500r = 13,375 – 500r. Setting the IS and LM curves equal to
each other and solving for r and Y yields that the equilibrium real output equals 12,312.5 and the
equilibrium interest rate equals 2.125. When the price level is 1.2, the equation of the IS curve is Y
= 11,500 + 1,500/1.2 – 500r = 12,750 – 500r. Setting the IS and LM curves equal to each other and
solving for r and Y yields that the equilibrium real output equals 10,125 and the equilibrium interest
rate equals 5.25. When the price level is 2.0, the equation of the IS curve is Y = 11,500 + 1,500/2.0
– 500r = 12,250 – 500r. Setting the IS and LM curves equal to each other and solving for r and Y
yields that the equilibrium real output equals 8,375 and the equilibrium interest rate equals 7.75.
The points on the aggregate demand curve are: (12,312.5, 0.8); (11,000, 1.0); (10,125, 1.2); and
(8,750, 2.0).
The aggregate demand curve in this problem is flatter than in Part b of Problem 1. Note that a
decrease in the price level from 1.0 to 0.8 causes real output to rise from 11,000 to 12,312.5 in this
problem, whereas the same drop in the price level causes real output to increase to only 12,125 in
Problem 1. Similarly, a rise in the price level from 1.0 to 1.2 causes real output to decline by 875
billion from 11,000 to 10,125 in this problem, whereas the decline is only 750 billion in Problem 1
for the same price increase.
The reason why the Pigou Effect results in a flatter aggregate demand curve is that a change in the
price level causes a change in autonomous spending. The change in autonomous spending causes
real output to increase and decrease by a larger quantity when the price level falls and rises,
respectively.
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