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Chapter 33

Aggregate Demand and Aggregate Supply

Educators


Problem 1

Suppose the economy is in a long-run equilibrium.
a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate demand,
short-run aggregate supply, and long-run aggregate supply.
b. Now suppose that a stock market crash causes aggregate demand to fall. Use your diagram
to show what happens to output and the price level in the short run. What happens to the unemployment rate?
c. Use the sticky-wage theory of aggregate supply to explain what will happen to output and the
price level in the long run (assuming no change in policy). What role does the expected price level
play in this adjustment? Be sure to illustrate your analysis in a graph.

Yi Chun L.
Washington University in St Louis

Problem 2

Explain whether each of the following events will increase, decrease, or have no effect on long-run
aggregate supply.
a. The United States experiences a wave of immigration.
b. Congress raises the minimum wage to $15 per hour.
c. Intel invents a new and more powerful computer chip.
d. A severe hurricane damages factories along the East Coast.

Yi Chun L.
Washington University in St Louis

Problem 3

Suppose an economy is in long-run equilibrium.
a. Use the model of aggregate demand and aggregate supply to illustrate the initial equilibrium (call it point A). Be sure to include both short-run and long-run aggregate supply.
b. The central bank raises the money supply by 5 percent. Use your diagram to show what
happens to output and the price level as the economy moves from the initial to the new short-run
equilibrium (call it point B).
c. Now show the new long-run equilibrium ( call it point C). What causes the economy to move from
point B to point C?
d. According to the sticky-wage theory of aggregate supply, how do nominal wages at point A
compare to nominal wages at point B? How do nominal wages at point A compare to nominal
wages at point C?
e. According to the sticky-wage theory of aggregate supply, how do real wages at point A compare to
real wages at point B? How do real wages at point A compare to real wages at point C?
f. Judging by the impact of the money supply on nominal and real wages, is this analysis consistent
with the proposition that money has real effects in the short run but is neutral in the long run?

Yi Chun L.
Washington University in St Louis

Problem 4

In 1939, with the U.S. economy not yet fully recovered from the Great Depression, President Roosevelt
proclaimed that Thanksgiving would fall a week earlier than usual so that the shopping period before
Christmas would be longer. Explain what President Roosevelt might have been trying to achieve, using the model of aggregate demand and aggregate supply.

Yi Chun L.
Washington University in St Louis

Problem 5

Explain why the following statements are false.
a. "The aggregate-demand curve slopes downward because it is the horizontal sum of the demand
curves for individual goods."
b. "The long-run aggregate-supply curve is vertical because economic forces do not affect long-run
aggregate supply."
c. "If firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal."
d. "Whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left."

Yi Chun L.
Washington University in St Louis

Problem 6

For each of the three theories for the upward slope of the short-run aggregate-supply curve, carefully
explain the following:
a. how the economy recovers from a recession and returns to its long-run equilibrium without any policy intervention
b. what determines the speed of that recovery

Yi Chun L.
Washington University in St Louis

Problem 7

The economy begins in long-run equilibrium. Then one day, the president appoints a new chair of the
Federal Reserve. This new chairman is well known for her view that inflation is not a major problem for an economy.
a. How would this news affect the price level that people would expect to prevail?
b. How would this change in the expected price level affect the nominal wage that workers and firms agree to in their new labor contracts?
c. How would this change in the nominal wage affect the profitability of producing goods and
services at any given price level?
d. How does this change in profitability affect the short-run aggregate-supply curve?
e. If aggregate demand is held constant, how does this shift in the aggregate-supply curve affect the
price level and the quantity of output produced?
f. Do you think this Fed chairman was a good appointment?

Yi Chun L.
Washington University in St Louis

Problem 8

Explain whether each of the following events shifts the short-run aggregate-supply curve, the aggregate demand curve, both, or neither. For each event that does shift a curve, draw a diagram to illustrate the
effect on the economy.
a. Households decide to save a larger share of their income.
b. Florida orange groves suffer a prolonged period of below-freezing temperatures.
c. Increased job opportunities overseas cause many people to leave the country.

Yi Chun L.
Washington University in St Louis

Problem 9

For each of the following events, explain the short-run and long-run effects on output and the price level,
assuming policymakers take no action.
a. The stock market declines sharply, reducing consumers' wealth.
b. The federal government increases spending on national defense.
c. A technological improvement raises productivity.
d. A recession overseas causes foreigners to buy fewer U.S. goods.

Yi Chun L.
Washington University in St Louis

Problem 10

Suppose firms become very optimistic about future business conditions and invest heavily in new capital equipment.
a. Draw an aggregate-demand/aggregate-supply diagram to show the short-run effect of this
optimism on the economy. Label the new levels of prices and real output. Explain in words why the
aggregate quantity of output $supplied$ changes.
b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. (For
now, assume there is no change in the long run aggregate-supply curve.) Explain in words why the aggregate quantity of output $demanded$ changes between the short run and the long run.
c. How might the investment boom affect the longrun aggregate-supply curve? Explain.

Yi Chun L.
Washington University in St Louis