Answers to Text Questions and Problems in Chapter 10 Answers to Review Questions 1. Stagflation is the combination of a recessionary gap and a rising price level. This situation is hard to depict on a Keynesian cross diagram, because the basic Keynesian model assumes that prices are constant. 2. This is the fallacy of composition. If the long-run aggregate supply curve is vertical, then a rise in the overall price level has no effect on potential output. 3. A horizontal short-run aggregate supply curve would occur if firms provide the output demanded by customers at the prices that the firms have posted. 4. False. The law of demand explains why a rise in the price of an individual good leads to a fall in the quantity demanded. This is because other prices are held constant, so consumers substitute away from the more-expensive good. However, the aggregate demand curve includes all goods, so there is no possible good to substitute toward if the overall price level rises. Instead, the aggregate demand curve shows an inverse relationship between the price level and output due to the real-balances effect, the interest rate effect, and the foreign trade effect. 5. Although the AD-AS model shows a self-correcting economy, a recessionary gap will take time to be eliminated. Therefore, expansionary macroeconomic policy can be used to eliminate the recessionary gap more quickly. 6. Stagflation is caused by an adverse price shock that shifts up the SRAS curve, leading to a lower level of output and a higher price level. 7. To some extent, the rationale for an upward-sloping SRAS curve and the rationale for an upwardsloping industry supply curve are the same: both are based on an assumption that input prices are held constant. In microeconomics, if the market price rises while all else is held constant, a profit-maximizing firm will find that its profit will rise if it produces more; this produces an upward-sloping supply curve. In macroeconomics, the assumption behind the upward-sloping SRAS curve is that input prices, such as wages, lag behind the price level; a rise in the price level therefore gives firms a profit incentive to expand output in the short run. 8. The short-run Phillips curve shows that, for given inflationary expectations, there is an inverse relationship between actual unemployment and the inflation rate. 9. The expectations-augmented Phillips curve model shows that there is an inverse relationship between unemployment and inflation only in the short run; once inflation adjusts, this relationship no longer exists. Therefore, there is no tradeoff between unemployment and inflation.

Answers to Problems 1.

The real value of your cash would fall to $1000/1.10 = $909.09.

2. In the short run, prices are fixed in the AD-AS model, so an increase in autonomous aggregate expenditure causes a rise in income that is the same as in the basic Keynesian model. This is depicted as the movement from A to B in the diagram below.

Price level

LRAS

B

SRAS

A

AD' AD

Output

Y*

In the long run, if the economy starts with a recessionary gap, then the increase in autonomous aggregate expenditure can bring GDP just to potential output, as in the movement from A to B below. Price level LRAS

B

SRAS

A

AD' AD

Output

Y*

However, if the economy starts at potential output, then the short-run rise in output (from A to B) leads to a rise in prices over time; as the short-run aggregate supply curve shifts up, output falls back to potential output (from B to C). Therefore, the multiplier is zero. Price level

LRAS C SRAS' B

SRAS

A AD' AD

Y*

Output

3a. b. c. d. e.

A rise in exports would cause the aggregate demand to shift right. The aggregate demand curve would shift left, as investment would fall. The short-run aggregate supply curve would shift up, as prices faced by consumers would rise. The fall in oil prices would make the short-run aggregate supply curve shift down. The aggregate demand curve would shift left, as exports would fall and imports would rise.

4. In the short run, the economy moves from A to B as the aggregate demand curve shifts right. Over time, the short-run aggregate supply curve shifts up, output falls back to potential output, and the economy moves from B to C. Price level

LRAS

C

SRAS'

B

SRAS

A AD' AD Y*

Output

5. If the actual rate of unemployment is higher than the natural rate, and policymakers implement expansionary macroeconomic policy to move the actual rate to the natural rate, then the inflation rate will increase over time and the economy will move up the (constant) short-run Phillips curve, from A to B. However, if instead policymakers allow the economy to self-correct, then eventually inflationary expectations will fall, shifting the short-run Phillips curve to the left (from A to C) and bringing the unemployment rate down to the natural rate. Β

LRPC

B A C

U*

SRPC SRPC' Unemployment rate

6. If the initial price level is 100, a two-percentage point drop in the price level would result in a new price level of 98. However, a two-percentage point drop in the inflation rate would result not in a lower price level, but in a slower rate of increase in the price level.

Sample Homework Assignment 1. a. b. c. 2. a. b. c.

Use the aggregate demand–aggregate supply model to explain the short-run and long-run effects on an economy of each of the following changes. An increase in imports. Expansionary monetary policy. An increase in oil prices. Suppose that AD is given by Price Level = 500 – 0.4Y, SRAS is given by Price Level = 120, and potential output is equal to 1000. What is short-run equilibrium output? If the economy is allowed to adjust on its own, what will be the price level and the level of output in the long run? Instead, if policymakers decide to use monetary policy to bring the economy back to potential output, what will be the new AD curve?

Multiple Choice Quiz 1. a. b. c. d. e.

What does the aggregate demand–aggregate supply model add to the basic Keynesian model? Fiscal policy. Monetary policy. Changes in output. Changes in prices. Changes in interest rates.

2. a. b. c. d. e.

The long-run aggregate supply curve is vertical. is horizontal. is upward-sloping. is downward-sloping. has a slope equal to zero.

3. a. b. c. d. e.

An improvement in technology will cause the short-run aggregate supply curve to shift up. the aggregate demand curve to shift right. the long-run aggregate supply curve to shift right. the aggregate demand curve to shift left. the long-run aggregate supply curve to shift left.

4. a. b. c. d. e.

The short-run aggregate supply curve will shift up if government spending rises. government spending falls. interest rates fall. input costs fall. input costs rise.

5. a. b. c. d. e.

Which of the following is not a reason for the downward slope of the aggregate demand curve? A fall in the price level causes the real value of money to rise. Higher prices mean that consumers spend more on foreign goods. Increased prices mean that consumers cannot afford to buy as many goods. A rise in prices will lower the real value of wealth in the economy. Lower prices make domestic goods more attractive on world markets.

6. a. b. c. d. e.

Expansionary fiscal policy will cause the aggregate demand curve to shift right. the aggregate demand curve to shift left. the short-run aggregate supply curve to shift right. the short-run aggregate supply curve to shift left. the long-run aggregate supply curve to shift right.

7.

If an economy is initially producing at less than potential output, how does it move to the long-run equilibrium? The aggregate demand curve shifts right. The short-run aggregate supply curve shifts up. The long-run aggregate supply curve shifts left. The short-run aggregate supply curve shifts down. The long-run aggregate supply curve shifts left.

a. b. c. d. e. 8. a. b. c. d. e.

Suppose that the LRAS is vertical at 10,000 and the AD curve is represented by P = 400 – 0.02Y. What is the price level in the long run? 400. 300. 200. 100. 0.

9. a. b. c. d. e.

Stagflation is the combination of a recessionary gap and a falling price level. a recessionary gap and a rising price level. an expansionary gap and a falling price level. an expansionary gap and a rising price level. no recessionary or expansionary gap, but a rising price level.

10. The long-run Phillips curve is a. downward-sloping. b. upward-sloping.

c. d. e.

horizontal at the natural rate of unemployment. vertical at the natural rate of unemployment. vertical at the current actual rate of unemployment.

Problems/Short Answer 1. a. b. c.

2. a. b. c.

Use the aggregate demand–aggregate supply model to explain the short-run and long-run effects on an economy of each of the following changes. A rise in exports brought about by a weaker currency. Contractionary fiscal policy. A fall in unionization that leads to lower wages throughout the economy.

Suppose that AD is given by Price Level = 440 – 0.3Y and SRAS is given by Price Level = 110. What is short-run equilibrium output? Suppose that input costs rise and SRAS is now given by Price Level = 125. Now what is short-run equilibrium output? Now suppose that policymakers want to use monetary policy to bring the economy back to the output in (a). What will the new AD curve have to be?

Answer Key to Extra Questions in Instructor’s Manual Sample Homework Assignment 1a. An increase in imports, holding all else constant, shifts the aggregate demand curve to the left. Output therefore falls in the short run, but the price level is constant. The recessionary gap causes prices to fall over time, shifting down the short-run aggregate supply curve. Output increases until it reaches the initial level, but at a permanently lower price level. b. Expansionary monetary policy shifts the aggregate demand curve to the right, raising output and opening up an expansionary gap. Over time, the price level increases, so the short-run aggregate supply curve shifts up and output returns to potential output, but at a permanently higher price level. c. An increase in oil prices shifts up the short-run aggregate supply curve and causes a recessionary gap. Over time, prices fall and the short-run aggregate supply curve shifts down. There is no long-run impact on output or the price level. 2a. 500 – 0.4Y = 120, so Y = 950. b. In the long run, output must be equal to potential output, or 1000. The price level must then be 500 – 0.4(1000) = 100. c. The new AD curve must be Price Level = 520 – 0.4Y.

Multiple Choice 1. 2. 3. 4.

d a c e

5. 6. 7. 8. 9. 10.

c a d c b d

Problems/Short Answer 1a. A rise in exports shifts the aggregate demand curve to the right. At the given price level, output has increased. Over time, firms will respond to the expansionary gap by raising prices; this shifts up the shortrun aggregate supply curve and brings output back to the initial level. b. Contractionary fiscal policy shifts aggregate demand left, causing output to fall in the short run. The recessionary gap will cause the price level to fall over time, shifting down the short-run aggregate supply curve until the economy returns to potential output. c. Lower wages represent lower input costs, allowing the short-run aggregate supply curve to shift down. The resulting expansionary gap will eventually cause firms to raise prices, bringing the economy back to the initial equilibrium point. 2a. 110 = 440 – 0.3Y, so Y = 1100. b. 125 = 440 – 0.3Y, so Y = 1050. c. The new AD curve must be Price Level = 455 – 0.3Y.