Download Foundations of Economics, 3e (Bade/Parkin)

Foundations of Economics, 3e (Bade/Parkin) - Testbank 3
Chapter 29 AS-AD and the Business Cycle
1) What is a business cycle? What are its phases and turning points?
Answer: A business cycle is the periodic but irregular up-and-down movement in production and jobs. It has
two phases and two turning points. As the economy slows and the growth in real GDP turns negative,
the economy enters the recession phase of the business cycle. At the bottom of the recession phase is
one turning point, the trough. As the economy moves through the trough, it enters the expansion part
of the business cycle during which real GDP grows. Finally, as the economy reaches its high point and
swings from an expansion to a recession, the economy passes through the other turning point, the
peak.
Topic: Business cycle
Skill: Level 1: Definition
Objective: Checkpoint 29.1
Author: AA
2) What is the NBER's definition of recession? Discuss the relationship between the phases of the business cycle,
real GDP and unemployment in the context of the United States economy from 1992 to the present.
Answer: The NBER defines a recession as a period of significant decline in total output, income, employment,
and trade, usually lasting at least six months to a year, and marked by widespread contractions in
many sectors of the economy. From 1992 to until March, 2001, the economy was in an expansion.
Then, the last U.S. recession started in March, 2001 and ended at the trough in November, 2001.
During the expansion that ended in 2001, real GDP rose above potential GDP and unemployment
generally fell to low levels. In the recession, real GDP fell below potential real GDP and
unemployment rose so that it was greater than the natural rate of unemployment. After the recession
ended in November, 2001 real GDP grew and the unemployment rate fell, though the growth in real
GDP and the fall in unemployment were both slow.
Topic: Business cycle
Skill: Level 2: Using definitions
Objective: Checkpoint 29.1
Author: CT
3) When total output, income, employment, and trade decline for 6 to 12 months, the economy is in what part
of the business cycle?
Answer: When these real variables decline, the economy is in the recession phase of the business cycle.
Topic: Business cycle
Skill: Level 2: Using definitions
Objective: Checkpoint 29.1
Author: MR
4) How does the average length of economic expansions and economic recessions in the United States in the
last half of the twentieth century compare with the average length during other periods of U.S. history?
Answer: The average length of expansions in the last half of the twentieth century has been much longer than at
any other time in U.S. history. Correspondingly, the average length of recessions in the last half of the
twentieth century has been much shorter than at any other time in U.S. history.
Topic: Business cycle
Skill: Level 1: Definition
Objective: Checkpoint 29.1
Author: AA
5) Name the four factors of production that determine the quantity of real GDP supplied. Which one fluctuates
the most over the course of the business cycle?
Answer: The factors are the quantity of labor employed, the quantities of capital and human capital and the
technologies they employ, the quantities of land and natural resources, and the amount of
entrepreneurial talent available. Over the course of a business cycle, the quantity of labor employed
fluctuates the most.
Topic: Aggregate supply
Skill: Level 1: Definition
Objective: Checkpoint 29.2
Author: NAU
6) What factor changes the quantity of real GDP supplied and results in a movement along the AS curve?
Answer: Changes in the price level change the quantity of real GDP supplied and result in a movement along
the AS curve.
Topic: Aggregate supply, price level
Skill: Level 1: Definition
Objective: Checkpoint 29.2
Author: TPS
7) Does a rise in the price level bring a movement along the aggregate supply curve or does it shift the
aggregate supply curve?
Answer: A rise in the price level results in an upward movement along the aggregate supply curve. It does not
shift the aggregate supply curve.
Topic: Aggregate supply, price level
Skill: Level 1: Definition
Objective: Checkpoint 29.2
Author: DMC
8) If the money wage rate is constant and the price level increases, what happens to the real wage rate, firms'
profits, and the aggregate quantity supplied?
Answer: The real wage rate falls. Because the price level has increased and money wage rates are constant
while real wage rates are lower, firms' profits increase. As a result, the aggregate quantity of goods
and services supplied increases.
Topic: Aggregate supply, price level
Skill: Level 3: Using models
Objective: Checkpoint 29.2
Author: WM
9) List three changes that lead to a shift of the aggregate supply curve. Discuss why each change shifts the
aggregate supply curve and in which direction the curve shifts.
Answer: A change in potential GDP, a change in the money wage rate, and a change in the money prices of
other resources shift the aggregate supply curve. If potential GDP increases (decreases) or the money
wage rate decreases (increases) or the money prices of other resources decrease (increase), aggregate
supply increases (decreases) and the AS curve shifts rightward (leftward).
Topic: Changes in aggregate supply
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: CT
10) How does a fall in the money wage rate affect the aggregate supply curve?
Answer: A fall in the money wage rate lowers firms' costs and shifts the aggregate supply curve rightward.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: DMC
11) Give examples of factors that decrease aggregate supply. Which way does the AS curve shift?
Answer: Aggregate supply decreases if potential GDP decreases. A rise in the money wage rate or the money
price of other resources such as the price of oil raises firms' costs and decreases aggregate supply. The
AS curve shifts leftward.
Topic: Aggregate supply curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: TPS
12) What is the effect on aggregate supply and potential GDP of an increase in the money wage rate?
Answer: An increase in the money wage rate decreases aggregate supply and shifts the aggregate supply curve
leftward. It has no effect on potential GDP.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: AA
13) "Moving along the AS curve, the real wage rate is constant while moving along the potential GDP line, the
real wage rate changes." Explain whether the previous statement is correct or incorrect.
Answer: The statement is incorrect. It reverses the situation. Moving along the AS curve, the money wage rate
is constant and so the real wage rate changes. Moving along the potential GDP line, money wage rates
have adjusted to the change in the price level and so the real wage rate is constant.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.2
Author: MR
14) What can lead to the shift illustrated in the figure above?
Answer: A decrease in the money wage rate or in the money prices of other resources, such as the price of oil,
increase aggregate supply and shift the AS curve rightward while not changing potential GDP.
Topic: Changes in aggregate supply, money wage rate
Skill: Level 3: Using models
Objective: Checkpoint 29.2
Author: MR
15) In the above figure, illustrate the effect on the AS curve from an increase in the money price of a key resource
such as oil.
Answer:
An increase in the money price of a key resource such as oil squeezes firms' profits and decreases
aggregate supply. As illustrated in the figure above, the AS curve shifts leftward, in the figure from
AS1 to AS2.
Topic: Changes in aggregate supply, money prices of resources
Skill: Level 3: Using models
Objective: Checkpoint 29.2
Author: WM
16) What is the effect on the aggregate demand curve from an increase in the price level? In particular, does the
aggregate demand curve shift leftward or rightward?
Answer: When the price level increases, there is a movement along the aggregate demand curve. The quantity
of real GDP demanded decreases in response to an increase in the price level. However, the aggregate
demand curve does not shift.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
17) How does an increase in the price level affect the aggregate quantity of goods and services demanded?
Answer: An increase in the price level decreases the aggregate quantity of goods and services demanded for
three reasons. First, it decreases the buying power of money. As a result, people decrease their
demand for goods and services. Second, it raises the real interest rate. The real interest rate rises
because an increase in the price level increases the demand for money, which raises the nominal
interest rate, which, in the short run, raises the real interest rate. When the real interest rate rises,
people and businesses delay plans for investment and purchases of big-ticket items. Finally, an
increase in the price level makes domestically produced goods and services more expensive relative to
foreign-produced goods and services. As a result, people and firms buy more foreign produced and
fewer domestically produced goods and services, which decreases the quantity demanded of
domestically produced goods and services.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
18) Explain the difference between a movement along the aggregate demand curve and a shift of the aggregate
demand curve.
Answer: There is a movement along the aggregate demand curve if there is a change in the price level. If some
factor that affects aggregate demand other than the price level changes, such as monetary or fiscal
policy, income in the rest of the world, or expectations, there is a shift in the aggregate demand curve.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: NAU
19) How does the aggregate demand curve reflect an increase in aggregate demand?
Answer: An increase in aggregate demand means that the aggregate demand curve shifts rightward.
Topic: Aggregate demand curve
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: DMC
20) State how each of the following affect the aggregate demand curve.
a. The price level increases.
b. Consumers expect higher inflation in the future.
c. The exchange rate rises.
d. Foreign income decreases.
Answer: a. There is a movement upward along the aggregate demand curve. The aggregate demand curve
does not shift.
b. The aggregate demand curve shifts rightward.
c. The aggregate demand curve shifts leftward.
d. The aggregate demand curve shifts leftward.
Topic: Changes in aggregate demand
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: CT
21) Give examples of factors that decrease aggregate demand. Which way does the aggregate demand curve
shift?
Answer: Anything that decreases spending decreases aggregate demand. A rise in the interest rate, a decrease
in the quantity of money, a decrease in government expenditures or a tax hike, and a decrease in real
GDP in the rest of the world all decrease spending and decrease aggregate demand. The aggregate
demand curve shifts leftward.
Topic: Changes in aggregate demand
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: TPS
22) How does a rise in the foreign exchange rate affect aggregate demand in the United States? Explain your
answer.
Answer: An increase in the foreign exchange rate decreases U.S. aggregate demand. The foreign exchange rate
is the amount of a foreign currency that a dollar can buy. If the exchange rate rises, a dollar buys more
foreign currency. As a result, foreign goods and services become cheaper to U.S. citizens because U.S.
citizens need to spend fewer dollars to buy foreign-produced goods and services. Simultaneously,
U.S.-produced goods and services become more expensive to foreigners because they must spend
more of their currency in order to buy the dollars necessary to buy the U.S.-produced goods and
services. As a result, U.S. imports increase and U.S. exports decrease, both of which decrease U.S.
aggregate demand.
Topic: Changes in aggregate demand, foreign exchange rate
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
23) How does a recession in Asia affect U.S. aggregate demand and the U.S. aggregate demand curve?
Answer: A recession in Asia means that Asians purchase fewer U.S.-made goods and services. As a result, U.S.
exports decrease so that U.S. aggregate demand decreases and the U.S. aggregate demand curve shifts
leftward.
Topic: Changes in aggregate demand, world income
Skill: Level 3: Using models
Objective: Checkpoint 29.3
Author: NAU
24) "An increase in Mexican income decreases aggregate demand in the United States." Is the preceding
statement correct or incorrect? Briefly explain your answer.
Answer: The statement is incorrect. An increase in Mexican income means that Mexican citizens buy more
goods and services exported from the United States. The increase in U.S. exports increases U.S.
aggregate demand.
Topic: Changes in aggregate demand, world income
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: AA
25) What are the two channels through which the world economy can affect U.S. aggregate demand? State what
changes in the world economy can increase U.S. aggregate demand.
Answer: The world economy can affect aggregate demand through the foreign exchange rate and foreign
income. If the foreign exchange rate falls, then U.S. aggregate demand increases because U.S. exports
become cheaper to foreign residents while U.S. imports become more expensive to U.S. citizens. If
foreign income increases, then U.S. aggregate demand increases because foreign citizens will spend
some of their increased income on U.S.-produced goods and services.
Topic: Changes in aggregate demand, world economy
Skill: Level 2: Using definitions
Objective: Checkpoint 29.3
Author: CT
26) "The aggregate demand multiplier results in the aggregate demand curve shifting by more than any given
initial change in expenditure." Is the previous statement correct or incorrect?
Answer: The statement is correct. The implication is that a, say $10 billion increase in investment shifts the
aggregate demand curve rightward by more than $10 billion.
Topic: Aggregate demand multiplier
Skill: Level 1: Definition
Objective: Checkpoint 29.3
Author: NAU
27) What is the aggregate demand multiplier and why does it occur?
Answer: The aggregate demand multiplier is an effect that magnifies changes in expenditure plans. So, for
example, if some component of expenditure such as investment increases, aggregate demand increases
by more than the increase in investment. The aggregate demand multiplier exists because when
aggregate demand increases, households' incomes increase. Then the increase in income results in an
increase in consumption expenditure, which adds to the initial increase in aggregate demand.
Topic: Aggregate demand multiplier
Skill: Level 1: Definition
Objective: Checkpoint 29.3
Author: TPS
28) What two variables are determined in an aggregate supply-aggregate demand figure? Is the slope of the
aggregate supply curve positive or negative? Is the slope of the aggregate demand curve positive or
negative?
Answer: The aggregate supply-aggregate demand framework determines the equilibrium price level and
equilibrium real GDP. The aggregate supply curve is positively sloped, indicating that an increase in
the price level increases the aggregate quantity of goods and services supplied. The aggregate demand
curve is negatively sloped, indicating that an increase in the price level decreases the aggregate
quantity of goods and services demanded.
Topic: Aggregate supply and aggregate demand model
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: WM
29) Explain how changes in foreign income can impact real GDP in a country.
Answer: Changes in the income of any nation impact the level of exports and imports of all other nations
trading with it. For example, in the United States aggregate demand increases if the income of our
trading partners, such as Mexico and Canada, increases because some of the increase in Mexican and
Canadian income translates into buying goods and services imported from the United States. As a
result, U.S. aggregate demand increases, which means that U.S. real GDP increases. Thus increases in
foreign income increase domestic real GDP while decreases in foreign income decrease domestic real
GDP.
Topic: Aggregate demand fluctuations
Skill: Level 4: Applying models
Objective: Checkpoint 29.4
Author: AA
30) How does a cut in interest rates that increases investment affect the quantity of real GDP demanded, the
aggregate demand curve, real GDP, and the price level?
Answer: The increase in investment increases the aggregate quantity demanded and shifts the AD curve
rightward. As a result, the equilibrium price level rises and the equilibrium real GDP increases.
Topic: Aggregate demand fluctuations
Skill: Level 4: Applying models
Objective: Checkpoint 29.4
Author: DMC
31) State how shifts in the aggregate demand curve can explain the movement of real GDP around potential
GDP.
Answer: When the aggregate demand curve and the aggregate supply curve intersect at the level of potential
GDP, then real GDP is equal to potential GDP. When something shifts the aggregate demand curve
rightward, then the aggregate demand curve and the aggregate supply curve will intersect at a level of
real GDP that is above potential GDP. The economy will be in an expansion. When something shifts
the aggregate demand curve leftward, then the aggregate demand curve and the aggregate supply
curve will intersect at a level of real GDP that is below potential GDP. The economy will be in a
recession.
Topic: Aggregate demand fluctuations
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: NAU
32) Can actual real GDP exceed potential GDP?
Answer: Yes, actual real GDP temporarily can exceed potential GDP as the economy nears a business cycle
peak.
Topic: Business cycles
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: DMC
33) Define potential GDP. Under what circumstances does actual real GDP fall short of potential GDP, equal
potential GDP, and exceed potential GDP?
Answer: Potential GDP is the level of real GDP that the economy produces when it is at full employment.
Potential GDP can be contrasted with actual real GDP, the amount of real GDP the country actually
produces. Actual real GDP can be less than potential GDP when the economy is producing at less than
full employment, that is, when there is less than full employment in the labor market. Actual real GDP
equals potential GDP when the economy is producing at full employment. Actual real GDP can exceed
potential GDP temporarily as the economy approaches and then recedes from a business cycle peak.
Topic: Business cycles
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: CT
34) Explain how fluctuations in aggregate supply impact real GDP.
Answer: Fluctuations in aggregate supply result in changes in real GDP. If potential GDP grows at an uneven
pace, real GDP fluctuates. Such a situation could be caused by a rapid technological change such as
was the case during the second half of the 1990s, when potential GDP grew quite rapidly. In addition,
price hikes for important natural resources, such as oil, can create drastic fluctuations in aggregate
supply. In this case, real GDP decreases and the economy enters a recession. Such a recession occurred
in the United States during the mid-1970s and then again in the early 1980s.
Topic: Aggregate supply fluctuations
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: AA
35) Define "stagflation" and explain how it can be created.
Answer: Stagflation is a combination of two words: stagnation and inflation. Stagnation means real GDP is
below the full employment level and falling, that is, the economy is in recession while at the same time
the price level is rising, that is, the economy is experiencing inflation. An increase in the price of a
major resource that decreases aggregate supply can trigger stagflation.
Topic: Stagflation
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: AA
36) What is an inflationary gap and how does the price level change? What is a deflationary gap and how does
the price level change?
Answer: An inflationary gap occurs when equilibrium real GDP (determined where the aggregate demand
curve intersects the aggregate supply curve) exceeds potential GDP. When an inflationary gap exists,
the price level rises. A deflationary gap occurs when equilibrium real GDP (determined where the
aggregate demand curve intersects the aggregate supply curve) is less than potential GDP. When a
deflationary gap exists, the price level falls.
Topic: Inflationary gap and recessionary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: TPS
37) Based on the table above,
a. What is the equilibrium price level and real GDP?
b. If potential GDP is $11.0 trillion, what does that imply about the economy's level of employment?
c. If potential GDP is $9.0 trillion, what does that imply about the economy's level of employment?
Answer: a. The equilibrium price level is 105; the equilibrium real GDP is $10.0 trillion.
b. If potential GDP is $11.0 trillion, then the economy is at an equilibrium that is a below fullemployment equilibrium with a recessionary gap.
c. If potential GDP is $9.0 trillion, then the economy is at an equilibrium that is an above fullemployment equilibrium with an inflationary gap.
Topic: Inflationary gap and recessionary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
38) How might an inflationary gap arise? How does the economy adjust to an inflationary gap?
Answer: An inflationary gap arises when aggregate demand increases and real GDP exceeds potential GDP.
With an inflationary gap, the price level has increased. These higher prices lead to workers demanding
higher wage rates. As firms increase money wage rates, aggregate supply decreases so that real GDP
decreases. Eventually, real GDP decreases enough so that it equals potential GDP and the economy is
back at its full employment equilibrium.
Topic: Inflationary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
39) Assume the equilibrium price level is 140 and the equilibrium real GDP is $15 trillion. What happens if the
current price level equals 125?
Answer: The quantity of real GDP demanded is greater than the quantity of real GDP supplied so there is an
inflationary gap. The price level rises to 140 because of the excess aggregate demand and when the
price level reaches 140, macroeconomic equilibrium is established. The rise in the price is inflation.
Topic: Inflationary gap
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: TPS
40) Suppose that during 2005, the actual real GDP of Chile was 3.5 billion pesos at the same time the potential
GDP was 3.4 billion pesos. What sort of equilibrium existed in Chile?
Answer: Chile's actual real GDP exceeded its potential GDP, so Chile was in an above full-employment
equilibrium with an inflationary gap.
Topic: Inflationary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
41) When the aggregate supply curve intersects the aggregate demand curve at a level of real GDP that exceeds
potential GDP, is there an inflationary gap or a deflationary gap? What adjustments will take place?
Answer: There is an inflationary gap because real GDP exceeds potential GDP. In this situation, the money
wage rate will rise, shifting the aggregate supply curve leftward and raising the price level. Eventually
the economy will return to potential GDP. At this time, real GDP is lower than when the inflationary
gap existed but the price level is higher.
Topic: Inflationary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: DMC
42) The economy is at full employment and then aggregate demand increases. Describe what happens as an
immediate result of the increase in aggregate demand. Describe how the economy adjusts back to full
employment.
Answer: The immediate effect of an increase in aggregate demand is to increase both the price level and real
GDP. The money wage rate does not change, so with the higher price level the real wage rate falls.
Eventually, however, workers demand a higher (money) wage rate to compensate for the higher price
level. As firms pay the higher money wage rate, aggregate supply decreases. The decrease in
aggregate supply means that the price level rises and real GDP decreases. Workers continue to
demand a higher money wage rate and aggregate supply continues to decrease until finally the
economy returns to full employment. At that point, the money wage rate has increased enough so that
the real wage rate is back to its initial level. Real GDP once again equals potential GDP, so the changes
in real GDP were only temporary. The price level, though, is higher than its initial level, so the
increase in the price level is permanent.
Topic: Inflationary gap
Skill: Level 3: Using models
Objective: Checkpoint 29.4
Author: WM
43) What is a recessionary gap? Can a recessionary gap arise from a decrease in aggregate demand?
Answer: A recessionary gap exists when potential GDP exceeds real GDP. A recessionary gap can arise from a
decrease in aggregate demand because the decrease in aggregate demand decreases real GDP.
Topic: Recessionary gap
Skill: Level 2: Using definitions
Objective: Checkpoint 29.4
Author: CT
44) If real GDP is less than potential GDP, what type of gap is the economy experiencing?
Answer: When real GDP is less than potential GDP, the economy is experiencing a recessionary gap.
Topic: Recessionary gap
Skill: Level 1: Definition
Objective: Checkpoint 29.4
Author: WM
45) What is the current equilibrium price level and real GDP for the economy illustrated in the figure above?
Does this economy have an inflationary gap, a recessionary gap, or neither? As it adjusts toward full
employment, which curve shifts? What is the equilibrium real GDP and price level that the economy will
ultimately reach?
Answer: The equilibrium is where the aggregate demand and aggregate supply curves intersect. Thus the
equilibrium price level is 110 and equilibrium real GDP is $10 trillion. Real GDP exceeds potential
GDP, so the economy has an inflationary gap. The aggregate supply curve will shift leftward as the
economy adjusts to full employment. Ultimately the aggregate supply curve will shift so that it
intersects the aggregate demand curve where the aggregate demand curve crosses the potential GDP
line. Thus ultimately equilibrium real GDP equals potential GDP, $9.5 trillion, and the price level is
120.
Topic: Inflationary gap
Skill: Level 4: Applying models
Objective: Checkpoint 29.4
Author: WM