Chapter 12: Aggregate Demand and Aggregate Supply

Question 1

What is the aggregate demand curve?

Answer 1

A graphical representation that shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world.

Question 2

Why does the aggregate demand curve have a negative slope?

Answer 2

Due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level.

Question 3

Why does the aggregate demand curve slope downwards?

Answer 3

The negative relationship between the aggregate price level and the quantity of aggregate output demanded (i.e., aggregate price level goes up, demand for aggregate output goes down)

Question 4

When we consider movements up or down the aggregate demand curve, we’re considering…

Answer 4

A simultaneous change in the prices of all final goods and services

Question 5

What is the wealth effect (of a change in the aggregate price level)?

Answer 5

The effect on consumer spending caused by the change in purchasing power of consumers’ assets when the aggregate price level changes. A rise in the aggregate price level decreases the purchasing power of consumers’ assets, so consumers decrease their consumption; a fall in the aggregate price level increases the purchasing power of consumers’ assets, so consumers increase their consumption.

Question 6

What is the interest rate effect (of a change in the aggregate price level)?

Answer 6

The effect on consumer spending and investment spending caused by a change in the purchasing power of consumers’ money holdings when the aggregate price level changes. A rise (fall) in the aggregate price level decreases (increases) the purchasing power of consumers’ money holdings. In response, consumers try to increase (decrease) their money holdings, which drives up (down) interest rates, thereby decreasing (increasing) consumption and investment.

Question 7

What does the aggregate demand curve do in relation to the income-expenditure model?

Answer 7

It’s a way to summarize what the income-expenditure model says about the effects of changes in the aggregate price level.

Question 8

A movement down the AD curve…

Answer 8

Leads to a lower aggregate price level and higher aggregate output.

Question 9

When does a rightward shift of the AD curve occur?

Answer 9

When the quantity of aggregate output demanded increases at any given price level (we call this an increase in demand or a positive AD shift).

Question 10

When does a leftward shift of the AD curve occur?

Answer 10

When the quantity of aggregate output demanded falls at any given price level (we call this a decrease in demand or an adverse/negative AD shift).

Question 11

What are the most important factors that can cause a shift in the aggregate demand curve?

Answer 11

Changes in expectations, changes in wealth, the size of the existing stock of physical capital, fiscal policy (contractionary and expansionary), and monetary policy (contractionary and expansionary).

Question 12

When consumers and firms become more optimistic…

Answer 12

Aggregate demand increases

Question 13

When consumers and firms become more pessimistic…

Answer 13

Aggregate demand decreases

Question 14

When the real value of household assets rise…

Answer 14

Aggregate demand increases

Question 15

When the real value of household assets fall…

Answer 15

Aggregate demand decreases

Question 16

When the existing stock of physical capital is relatively small…

Answer 16

Aggregate demand increases

Question 17

When the existing stock of physical capital is relatively large…

Answer 17

Aggregate demand decreases

Question 18

When the government increases spending or cuts taxes…

Answer 18

Aggregate demand increases

Question 19

When the government reduces spending or raises taxes…

Answer 19

Aggregate demand decreases

Question 20

When the central bank increases the quantity of money supplied…

Answer 20

Aggregate demand increases

Question 21

When the central bank reduces the quantity of money supplied…

Answer 21

Aggregate demand decreases

Question 22

Why do changes in expectations cause a shift in the aggregate demand curve?

Answer 22

Both consumer spending and planned investment spending depend on people’s expectations about the future. Consumers base their spending not only on the income they have now but also on the income they expect to have in the future. Firms base their planned investment spending not only on current conditions but also on the sales they expect to make in the future. As a result, changes in expectations can push consumer spending and planned investment spending up or down. If consumers and firms become more optimistic, aggregate expenditure rises; if they become more pessimistic, aggregate expenditure falls (due to a decrease in autonomous consumption and/or autonomous investment).

Question 23

Which surveys do forecasters pay attention to concerning consumer and business sentiment?

Answer 23

Index of Consumer Confidence (monthly) and Index of Business Confidence (quarterly), both from the Conference Board of Canada, and the Business Outlook Survey (quarterly) from the Bank of Canada.

Question 24

Why do changes in wealth cause a shift in the aggregate demand curve?

Answer 24

Consumer spending depends in part on the value of household assets. When the real value of these assets rises, the purchasing power they embody also rises, leading to an increase in aggregate expenditure (and an increase in aggregate demand).

Question 25

What is the difference between movement along the AD curve and a shift of the AD curve?

Answer 25

The difference depends on the source of the change in wealth. Movement along the AD curve occurs when a change in the aggregate price level changes the purchasing power of consumers’ existing wealth (the real value of their assets). A change in the aggregate price level is the source of a change in wealth. For example, a fall in the aggregate price level increases the purchasing power of consumers’ assets and leads to movement down the AD curve.

In contrast, a change in wealth independent of a change in the aggregate price level shifts the AD curve. For example, a rise in the stock market or a rise in real estate values leads to an increase in the real value of consumers’ assets at any given aggregate price level. In this case, the source of the change in wealth is a change in the value of assets without any change in the aggregate price level - that is, a change in asset values holding the prices of all final goods and services constant.

Question 26

Why does the size of the existing stock of physical capital shift the AD curve?

Answer 26

Firms engage in planned investment spending to add to their stock of physical capital. Their incentive to spend depends in part on how much physical capital they already have: the more they have, the less they will feel a need to add more, other things equal. The same applies to other types of investment spending. When firms spend more on physical capital, aggregate expenditure increases and the AD curve shifts to the right.

Question 27

Why do governments use fiscal policy?

Answer 27

To stabilize the economy. Governments often respond to recessions by increasing spending, cutting taxes, or both. They often respond to inflation by reducing spending or increasing taxes.

Question 28

Why is government spending on goods and services (G) a direct effect on the economy?

Answer 28

Because government purchases are themselves a component of aggregate demand. So an increase in government purchases shifts the aggregate demand curve to the right and decreases shift it to the left.

Question 29

Because of World War II, real government purchases of goods and services surged…

Answer 29

570%

Question 30

What are some examples of goverments increasing purchases of goods and services to stabilize the economy?

Answer 30

World War II: End of Great Depression, Japan 1990s: large public works projects and infrastructure to increase AD in a slumping economy, Canada 2009: Spent more than $63 billion on infrastructure projects

Question 31

Why are government taxes or transfers an indirect effect on the economy?

Answer 31

A lower tax rate means that consumers get to keep more of what they earn, increasing their disposable income. An increase in government transfers also increases consumers’ disposable income. In either case, this increases consumer spending and shifts the aggregate demand curve to the right.

Question 32

Why do governments use monetary policy?

Answer 32

To stabilize the economy. A rise in the aggregate price level, by reducing the purchasing power of money holdings, causes a rise in the interest rate. That, in turn, reduces both investment spending and consumer spending. Additionally, when the central bank increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. The effect is to drive the interest rate down at any given aggregate price level, leading to higher investment spending and higher consumer spending.

Question 33

What happened to the economy right after the oil crisis in 1979 in Canada?

Answer 33

Faced with a sharp increase in the aggregate price level - the rate of consumer price inflation reached 12.9% in July of 1981 - the BoC stuck to a policy of slowly increasing the quantity of money. The aggregate price level was rising more steeply, but the quantity of money circulating in the economy was growing slowly. The net result was that the purchasing power of the quantity of money in circulation fell. This led to an increase in demand for borrowing and a surge in interest rates. High interest rates caused both consumer spending and investment spending to fall.

In other words, in 1979-1982, the economy responded just as we would expect if it was moving upward along the aggregate demand curve from right to left: due to the wealth effect and interest rate effect of a change in the aggregate price level, the quantity of output demanded fell as the aggregate price level rose.

Question 34

What does the AD curve show?

Answer 34

How income-expenditure equilibrium GDP changes when the aggregate price level changes.

Question 35

Determine the effect on aggregate demand of a rise in the interest rate caused by a change in monetary policy. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward).

Answer 35

Shift curve leftward. A decrease in the quantity of money raises the interest rate, since people borrow more and lend less. A higher interest rate reduces investment and consumer spending at any given aggregate price level. So, the aggregate demand curve shifts to the left.

Question 36

Determine the effect on aggregate demand of a fall in the real value of money in the economy due to a higher aggregate price level. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward).

Answer 36

Movement up along the AD curve. As the aggregate price level rises, the real value of money holdings falls. This is the interest rate effect of a change in the aggregate price level: as the value of money falls, people want to hold more money. They do so by borrowing more and lending less. This leads to a rise in the interest rate and a reduction of consumer and investment spending, So it is movement along the AD curve.

Question 37

Determine the effect on aggregate demand of news of a worse-than-expected job market next year. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward).

Answer 37

This is a shift of the AD curve. Expectations of a poor job market, and so lower-than-average disposable incomes, will reduce people’s consumer spending today at any given aggregate price level. So the AD curve shifts to the left.

Question 38

Determine the effect on aggregate demand of a fall in taxes. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward).

Answer 38

This is a shift of the AD curve. A fall in taxes raises people’s disposable income. At any given aggregate price level, consumer spending is now higher. So the aggregate demand curve shifts to the right.

Question 39

Determine the effect on aggregate demand of a rise in the real value of assets in the economy due to a lower aggregate price level. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward).

Answer 39

Movement down the AD curve. As the aggregate price level falls, the real value of assets rises. This is the wealth effect of a change in the aggregate price level: as the value of assets rises, people will increase their consumption plans. This leads to higher consumer spending. So it is movement along the aggregate demand curve.

Question 40

Determine the effect on aggregate demand of a rise in the real value of assets in the economy due to a surge in real estate values. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward).

Answer 40

This is a shift of the AD curve. A rise in the real value of assets in the economy due to a surge in real estate values raises consumer spending at any given aggregate price level. So the AD curve shifts to the right.

Question 41

What is the aggregate supply curve?

Answer 41

A graphical representation that shows the relationship between the aggregate price level and the total quantity of aggregate output supplied.

Question 42

What is the kind of relationship between the aggregate price level and the total quantity of aggregate output supplied?

Answer 42

Positive (meaning the AS curve slopes upward).

Question 43

What is the formula for profit per unit output?

Answer 43

Profit per unit of output = Price per unit of output - Production cost per unit of output

Question 44

What is a nominal wage?

Answer 44

The dollar amount of any given wage paid.

Question 45

What are sticky wages?

Answer 45

Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labour shortages.

Question 46

What are wages?

Answer 46

All forms of worker compensation, such as employer-paid healthcare and retirement benefits in addition to earnings.

Question 47

Why does the short-run AS curve slope upwards?

Answer 47

Producers make output decisions based on their profit per unit of output.

In perfectly competitive markets (takes prices as given): Suppose that for some reason the aggregate price level rises. As a result, the typical producer receives a higher price for its final good or service. Again, many production costs are fixed in the short run, so production cost per unit of output doesn’t rise by the same proportion as the rise in the price of a unit. And since the typical perfectly competitive producer takes the price as given, profit per unit of output rises and output increases

In imperfectly competitive markets (able to set prices): If there is a rise in demand for this producer’s product, it will be able to sell more at any given price. Given stronger demand for its products, it will probably choose to increase its prices as well as its output, as a way of increasing profit per unit of output.

Both responses lead to an upward-sloping relationship between aggregate output and the aggregate price level.

Question 48

What is the short-run AS curve?

Answer 48

A graphical representation that shows the positive relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs, particularly nominal wages, can be taken as fixed. The short-run aggregate supply curve has a positive slope because a rise in the aggregate price level leads to a rise in profits, and therefore output, when production costs are fixed.

Question 49

What does movement down the SRAS curve lead to?

Answer 49

Deflation and lower aggregate output.

Question 50

Why are some nominal wages flexible even in the short run?

Answer 50

Some workers are not covered by a contract or informal agreement with their employers. Since some nominal wages are sticky but others are flexible, the average nominal wage falls when there is a steep rise in unemployment.

Question 51

Why are some prices of final goods and services sticky rather than flexible?

Answer 51

Some firms, particularly the makers of luxury or name-brand goods, are reluctant to cut prices even when demand falls. Instead, they prefer to cut output even if their profit per unit hasn’t declined.

Question 52

When does the SRAS curve shift?

Answer 52

Aggregate supply decreases when producers reduce the quantity of aggregate output they are willing to supply at any given aggregate price level, which shifts the curve left. Aggregate supply increases when producers increase the quantity of aggregate output they are willing to supply at any given aggregate price level, which shifts the curve right. Anything that causes increases in per unit profit will cause a rightward shift of the SRAS curve, and anything that causes decreases in per unit profit will cause a leftward shift of the SRAS curve.

Question 53

What are the three main factors that shift the SRAS curve?

Answer 53

Changes in commodity prices, changes in nominal wages, and changes in productivity or regulation.

Question 54

How do changes in commodity prices shift the SRAS curve?

Answer 54

Commodities (i.e., oil) are not a final good or service and are not included in the calculation of the aggregate price level. An increase in the price of commodities raises production costs across the economy and reduces the quantity of aggregate output supplied at any given aggregate price level. This shifts the aggregate supply curve to the left.

Question 55

How do changes in nominal wages shift the SRAS curve?

Answer 55

Suppose, for example, that there is an economy-wide rise in the cost of healthcare insurance premiums paid by employers as part of employees’ wages. From the employer’s perspective, this is equivalent to a rise in nominal wages because it is an increase in employer-paid compensation. So the rise in nominal wages increases production costs and shifts the SRAS curve left.

Question 56

What was the indirect effect of the 1970s surge in oil prices on nominal wages?

Answer 56

Many wage contracts included cost-of-living allowances that automatically raised the nominal wage when consumer prices increased. Through this channel, the surge of oil in the price of oil - which led to an increase in overall consumer prices - ultimately caused a rise in nominal wages.

Question 57

How do changes in productivity shift the SRAS curve?

Answer 57

An increase in productivity means that a worker can produce more units of output with the same quantity of inputs. For example, bar-code scanners greatly increased the ability of a single worker to stock, inventory, and resupply store shelves. As a result, the cost to a store of “producing” a dollar worth of sales fell, profits rose, and the quantity supplied increased. So a rise in productivity, whatever the source, increases producers’ profits per unit produced and shifts the SRAS curve right.

Question 58

When commodity prices fall…

Answer 58

Aggregate supply increases

Question 59

When commodity prices rise…

Answer 59

Aggregate supply decreases

Question 60

When nominal wages fall…

Answer 60

Aggregate supply increases

Question 61

When nominal wages rise…

Answer 61

Aggregate supply decreases

Question 62

When workers become more productive…

Answer 62

Aggregate supply increases

Question 63

When workers become less productive…

Answer 63

Aggregate supply decreases

Question 64

In the long run, what is the relationship between the aggregate price level and the quantity of aggregate output supplied?

Answer 64

The aggregate price level has no effect on the quantity of aggregate output supplied in the long run.

Question 65

What is considered the long run?

Answer 65

The period of time in which all prices, including production costs such as nominal wages, are perfectly, or fully flexible.

Question 66

What is the long run aggregate supply curve?

Answer 66

A graphical representation that shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. The long-run aggregate supply curve is vertical because the aggregate price level has no effect on the quantity of aggregate output supplied in the long run. In the long run, output is determined by the economy’s potential output.

Question 67

What is potential output?

Answer 67

The level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. Despite what the label might imply, potential output is not the economy’s maximum level of output; rather, it is equal to the level of real output the economy would produce when all factors of production (both inputs and technology) are effectively and fully utilized.

Question 68

What are some other names for potential output?

Answer 68

Natural rate level of ouput (Ynr), the full employment level of output (Yfe), or the long-run equilibrium level of output (Ylr*).

Question 69

What are some of the Canadian institutions that estimate annual potential output for the purpose of federal budget analysis?

Answer 69

Bank of Canada, the office of the Parliamentary Budget Officer, and the Federal Department of Finance.

Question 70

What is the output gap?

Answer 70

The percentage difference between actual aggregate output and potential output.

Question 71

What does the output gap gauge?

Answer 71

The performance of the economy relative to the long-run (potential) trend. When the output gap is negative, actual real output is below the long-run potential level, so the economy is underperforming relative to the long-run trend or potential level of GDP. A positive output gap implies greater inflationary pressure exists in the economy - the larger the gap, the more inflationary pressure is implied.

Question 72

What level of output does the economy normally produce?

Answer 72

More or less than potential output.

Question 73

What happens when the economy is on the SRAS curve but not the LRAS curve?

Answer 73

The SRAS will shift over time (i.e., when nominal wages are adjusted) until the economy is at a point when both curves cross - a point where actual output is equal to potential output.

Question 74

Determine the effect on short-run aggregate supply when a rise in the consumer price index (CPI) leads producers to increase output. Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve.

Answer 74

Movement along the SRAS curve because CPI, like GDP deflator, is a measure of the aggregate price level.

Question 75

Determine the effect on short-run aggregate supply when a fall in the price of oil leads producers to increase output. Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve.

Answer 75

This will shift the SRAS curve because oil is a commodity. The SRAS curve will shift to the right because production costs are now lower, leading to a higher quantity of aggregate output supplied at any given aggregate price level.

Question 76

Determine the effect on short-run aggregate supply when a rise in legally mandated retirement benefits paid to workers leads producers to reduce output. Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve.

Answer 76

This will shift the SRAS curve because it involves a change in nominal wages. An increase in legally mandated benefits to workers is equivalent to an increase in nominal wages. As a result, the SRAS curve will shift leftward because production costs are now higher, leading to a lower quantity of aggregate output supplied at any given aggregate price level.

Question 77

Suppose the economy is initially at potential output and the quantity of aggregate output supplied increases. What information would you need to determine whether this was due to a movement along the SRAS curve or a shift of the LRAS curve?

Answer 77

I would need to know what happened to the aggregate price level. If the increase was due to movement along the SRAS curve, the aggregate price level would have increased at the same time the quantity of output supplied increased. If the increase was due to a shift of the LRAS curve, the aggregate price level may not rise.

I could also assess what happened to the aggregate output supplied. If it fell back to its initial level in the long run, the increase in aggregate output was due to movement along the SRAS curve. If it stayed at a higher level in the long run, the increase was due to a shift in the LRAS curve.

Question 78

What is the AD-AS model?

Answer 78

The basic model used to understand fluctuations in aggregate output and the aggregate price level. It uses the aggregate supply curve and the aggregate demand curve together to analyze the behaviour of the economy in response to shocks or government policy.

Question 79

What is the short-run macroeconomic equilibrium?

Answer 79

The point at which the quantity of aggregate output supplied is equal to the quantity demanded.

Question 80

What is the short-run equilibrium aggregate price level?

Answer 80

The aggregate price level in short-run macroeconomic equilibrium.

Question 81

What is the short-run equilibrium aggregate output?

Answer 81

The quantity of aggregate output produced in the short-run macroeconomic equilibrium.

Question 82

What happens if the aggregate price level is above its equilibrium level?

Answer 82

The quantity of aggregate output supplied exceeds the quantity of aggregate output demanded. This leads to a fall in the aggregate price level and pushes it toward its equilibrium level.

Question 83

What is demand shock?

Answer 83

An event that shifts the aggregate demand curve. A positive demand shock is associated with higher demand for aggregate output at any price level and shifts the curve to the right. A negative demand shock is associated with lower demand for aggregate output at any price level and shifts the curve to the left. An example of a positive demand shock is expansionary fiscal policy.

Question 84

What kind of demand shock caused the Great Depression? What kind of demand shock ended the Great Depression?

Answer 84

A negative demand shock caused the Great Depression - the collapse of wealth and business and consumer confidence that followed the stock market crash of 1929 and US banking crisis of 1930-1931.

A positive demand shock ended the Great Depression - the huge increase in government purchases during World War II.

Question 85

A negative demand shock…

Answer 85

Leads to a lower aggregate price level and lower aggregate output.

Question 86

A positive demand shock…

Answer 86

Leads to a higher aggregate price level and higher aggregate output.

Question 87

What is supply shock?

Answer 87

An event that shifts the short-run aggregate supply curve. A negative supply shock raises production costs and reduces the quantity supplied at any aggregate price level, shifting the curve leftward. A positive supply shock decreases production costs and increases the quantity supplied at any aggregate price level, shifting the curve rightward. An example of a positive supply shock is technological improvement having an effect of increasing per unit profit for the given price level. An example of a negative supply shock is a recession abroad or increase in oil prices, causing the per unit profit to decrease.

Question 88

A negative supply shock…

Answer 88

Leads to lower aggregate output and a higher aggregate price level.

Question 89

A positive supply shock…

Answer 89

Leads to higher aggregate output and a lower aggregate price level.

Question 90

What is stagflation?

Answer 90

The combination of inflation and falling aggregate output (which results from negative supply shocks).

Question 91

What is the long-run macroeconomic equilibrium?

Answer 91

The point at which the short-run macroeconomic equilibrium is on the long-run aggregate supply curve; so short-run equilibrium aggregate output is equal to potential output.

Question 92

An initial negative demand shock….

Answer 92

Reduces the aggregate price level and aggregate output and leads to higher unemployment in the short run, until an eventual fall in nominal wages in the long run increases short-run aggregate supply and moves the economy back to potential output.

Question 93

What is a recessionary gap?

Answer 93

The gap that exists when aggregate output is below potential output. A recessionary gap inflicts a great deal of pain because it corresponds to high unemployment.

Question 94

An initial positive demand shock…

Answer 94

Increases the aggregate price level and aggregate output and reduces unemployment in the short run, until an eventual rise in nominal wages in the long run reduces short-run aggregate supply and moves the economy back to potential output.

Question 95

What is an inflationary gap?

Answer 95

The gap that exists when aggregate output is above potential output.

Question 96

What is the output gap (formula)?

Answer 96

Output gap = (Actual aggregate output - Potential output)/Potential Output * 100

Question 97

How is the economy self-correcting (in relation to output gaps)?

Answer 97

If there is a recessionary gap, so the output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero. If there is an inflationary gap, so the output gap is positive, nominal wages eventually rise, moving the economy back to potential output and bringing the output gap back to zero.

Question 98

What is self-correcting (definition)?

Answer 98

Describes an economy in which shocks to aggregate demand affect aggregate output in the short run but not the long run.

Question 99

What primarily causes recessions?

Answer 99

Demand shocks. But, when a negative supply shock does happen, the resulting recession tends to be particularly severe.

Question 100

How many recessions have there been in Canada since WWII?

Answer 100

11, with two being a double-dip recession.

Question 101

Describe the short-run effects of the government sharply increasing the minimum wage, raising the wages of many workers, on the aggregate price level and on aggregate output.

Answer 101

An increase in the minimum wage raises the nominal wage and, as a result, shifts the SRAS curve left, a negative supply shock, which decreases output and increases price level.

Question 102

Describe the short-run effects of solar energy firms launching a major program of investment spending, on the aggregate price level and on aggregate output.

Answer 102

Increased investment spending shifts the demand curve to the right. As a result of this positive demand shock, both the aggregate price level and aggregate output rise.

Question 103

Describe the short-run effects of the Parliament raising taxes and cutting spending, on the aggregate price level and on aggregate output.

Answer 103

An increase in taxes and reduction in government spending both result in negative demand shocks, shifting the AD curve to the left. As a result, the aggregate price level rises and aggregate output falls.

Question 104

Describe the short-run effects of severe weather destroying crops around the world, on the aggregate price level and on aggregate output.

Answer 104

This is a negative supply shock, shifting the short-run aggregate supply curve to the left. As a result, the aggregate price level rises and aggregate output falls.

Question 105

A rise in productivity increases potential output, but some worry that demand for the additional output will be insufficient even in the long run. How would you respond?

Answer 105

As the rise in productivity increases potential output, the LRAS curve shifts to the right. If, in the short run, there is now a recessionary gap (aggregate output is less than potential output), nominal wages will fall, shifting the SRAS curve to the right. This results in a fall in the aggregate price level and a rise in aggregate output. As prices fall, we move along the aggregate demand curve due to wealth and interest rate effects of a change in the aggregate price level. Eventually, as long-run macroeconomic equilibrium is reestablished, aggregate output will rise to equal potential output.

Question 106

What happens to planned aggregate expenditure when prices change in the economy?

Answer 106

If there is an increase in the price index, real GDP falls. Why? Because of the wealth effect (reduced asset value leads to reduced purchasing power leads to a downward shift of AE(planned)) and the interest rate effect (increase in price index leads to decreases in money holdings leads to reduced savings leads to increase in the interest rate leads to reduced consumption and investment leads to a downward shift of AE (planned)).

Question 107

What is the law of diminishing marginal productivity?

Answer 107

It implies that at some point the marginal product of labour declines as the number of workers employed rises. This implies that layoffs raise the marginal productivity of labour, and this higher productivity works to lower per unit production costs.

Question 108

What are the pros and cons of stabilization policy?

Answer 108

The economy need not suffer in the short run, and price stability is a desirable outcome. But expansionary policy may involve undesirable outcomes largely due to a lack of precision and delays in implementing them. Aggregate demand management during inflationary gaps is desirable. Responding to supply shocks is more challenging, the government cannot make the AS curve move so easily.