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Ragan/Lipsey 11th edition (Chapter 23)
Question 9
a) A horizontal AS curve reflects the fact that firms are prepared to supply any amount of
output that is demanded of them without requiring an increase in prices. There are two
situations that might lead to this “passive” supply response. The first is when the
economy has many unemployed resources, both labour and capital. In this case, firms
have excess capacity and they can increase output easily without driving up unit costs.
The second situation is where firms are price setters — that is, they have market power in
the markets in which they sell their products. Price-setting firms often respond to changes
in demand by initially changing their level of output, only later adjusting their prices.
b) An upward sloping AS curve reflects the fact that firms are only prepared to supply
more output if prices rise. This is expected in situations where firms can only increase
their output by using their existing resources, especially capital, more intensively. The
“law” of eventually diminishing returns to the variable factor (usually labour) means that
increases in output may only be possible by driving up unit production costs, thus
requiring a rise in prices.
c) Output is said to be demand determined in Economy A, the one with the horizontal AS
curve. In this economy, the AD curve alone determines the level of equilibrium GDP.
d) An increase in autonomous expenditure, leads to a rightward shift of the AD
curve. The distance of the shift is exactly equal to the change in autonomous expenditure
times the simple multiplier, z. This is true in both economies. In Economy A, the AS
curve is horizontal and so equilibrium GDP changes by the full amount of the AD shift.
In Economy B, however, the change in equilibrium GDP is less than the full shift because
the price level rises. As the price level rises, desired aggregate expenditure is choked off
— this is a movement upward and along the new AD curve. Thus Economy A, the one
with demand-determined output, has a larger multiplier than Economy B.
Question 10
a) The AD curve is given by:
YAD = 710 – 30P + 5G
This AD curve is entirely conventional. The first term includes the effects of autonomous
expenditure such as consumption, investment, and exports. The second term shows that
increases in the price level lead to reductions in wealth and thus to reductions in desired
expenditure. The third term shows separately the effect of government purchases, and
shows that an increase in G leads to a rightward shift of the AD curve.
What is the simple multiplier? If we held the price level constant, as in Chapters
21 and 22, the simple multiplier would be given by the amount by which a $1 increase in
G increased equilibrium GDP. The coefficient on G in the AD curve is this simple
multiplier. A $1 increase in G leads to a rightward shift of the AD curve by $5.
b) The AS curve is given by:
YAS = 10 + 5P – 2POIL
This is also entirely conventional. The amount of output firms are willing to supply
increases when the price level rises. When firms increase output, the law of diminishing
returns means that their unit costs are driven up, and so they are only prepared to provide
more output at a higher price level. Oil is an important input to the production process for
many firms, and so a rise in the price of oil, other things equal, leads to an increase in
firms’ costs. This reduces the amount of output that firms are prepared to supply.
c) To solve this two-equation system, we equate YAD with YAS. In this way, we are finding
the level of Y where the two curves intersect. Doing this, we get:
710 – 30P + 5G = 10 + 5P – 2POIL
Now we want to solve this equation for the equilibrium level of P, which will depend on
the two exogenous variables, G and POIL. Combining terms and rearranging, we get:
700 + 5G + 2POIL = 35P  P* = 20 + (1/7)G + (2/35)POIL
Now we substitute this value of P* into either the AD or the AS curve to get the
equilibrium level of real GDP. Using the AD curve we get:
Y* = 710 + 5G – 30[20 + (1/7)G + (2/35)POIL]

Y* = 710 + 5G – 600 – (30/7)G – (60/35)POIL

Y* = 110 + (5/7)G – (12/7)POIL
d) What is the effect of a change in G? From the equation for P*, it is clear that a rise in
G leads to an increase in the price level. From the equation for Y*, it is clear that a rise in
G leads to a rise in real GDP. This is exactly what we would expect from a positive
aggregate demand shock when the AS curve is upward sloping.
e) What is the effect of a change in POIL? From the equation for P*, it is clear that a rise in
POIL leads to an increase in the price level. From the equation for Y*, it is clear that a rise
in POIL leads to a fall in real GDP. This is exactly what we would expect from a negative
aggregate supply shock when the AD curve is downward sloping.