Module 5-Practice Questions

Chapter 14:
1. Suppose that the economy is in a long-run equilibrium.
a. Use 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 there is no change in policy). What role does the expected
price level play in this adjustment? Be sure to illustrate your analysis in a graph.

2. Explain whether each of the following events will increase, decrease, or have no effect on
long-run aggregate supply.
a. Canada experiences a wave of immigration.
b. Provincial and territorial governments raise 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.
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?

4. 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.”

5. Suppose that the economy is currently in a recession. If policymakers take no action, how
will the economy evolve over time? Explain in words and using an aggregate-demand/aggregate-
supply diagram.
6. Suppose that firms become very optimistic about future business conditions and invest
heavily in new capital equipment.
a. Use 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 long-run aggregate-supply curve? Explain.

Chapter 15:
1. Explain how each of the following developments would affect the supply of money, the
demand for money, and the interest rate. For each case, show what happens in a closed
economy and in a small open economy. Illustrate your answers with diagrams.
a. The Bank of Canada’s bond traders buy bonds in open-market operations.
b. An increase in credit card availability reduces the cash people hold.
c. Households decide to hold more money to use for holiday shopping.
d. A wave of optimism boosts business investment and expands aggregate demand.
e. An increase in oil prices shifts the short-run aggregate-supply curve to the left.

2. Suppose economists observe that in a closed economy an increase in government spending

of $10 billion raises the total demand for goods and services by $30 billion.
a. If these economists ignore the possibility of crowding out of investment, what would they
estimate the marginal propensity to consume (MPC) to be?
b. Now suppose the economists allow for crowding out. Would their new estimate of the MPC
be larger or smaller than their initial one?
3. In which of the following circumstances is expansionary fiscal policy more likely to lead to a
short-run increase in investment? Explain.
a. when the investment accelerator is large, or when it is small
b. when the interest sensitivity of investment is large, or when it is small
c. when the marginal propensity to import is small, or when it is large

4. Suppose that U.S. income rises. As a result, Canada’s exports to the United States increase.
What happens to the position of the aggregate-demand curve in Canada? Assume that the Bank
of Canada allows the exchange rate to be flexible. How does your answer change if you assume
that the Bank of Canada maintains a fixed exchange rate? Illustrate your answer with diagrams.

Chapter 16:
1. Suppose the economy is in a long-run equilibrium.
a. Draw the economy’s short-run and long-run Phillips curves.
b. Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this
shock on your diagram from part (a). If the Bank of Canada undertakes expansionary monetary
policy, can it return the economy to its original inflation rate and original unemployment rate?
c. Now suppose the economy is back in long-run equilibrium, and then the price of imported oil
rises. Show the effect of this shock with a new diagram like that in part (a). If the Bank of
Canada undertakes expansionary monetary policy, can it return the economy to its original
inflation rate and original unemployment rate? If the Bank of Canada undertakes contractionary
monetary policy, can it return the economy to its original inflation rate and original
unemployment rate? Explain why this situation differs from that in part (b).

2. Suppose the Bank of Canada believed that the natural rate of unemployment was 6 percent
when the actual natural rate was 5.5 percent. If the Bank of Canada based its policy decisions
on its belief, what would happen to the economy?
3. The price of oil fell sharply in 1986, again in 1998, and again in 2015.
a. Show the impact of such a change in both the aggregate-demand/aggregate-supply diagram
and in the Phillips curve diagram. What happens to inflation and unemployment in the short
run?
b. Do the effects of this event mean there is no short-run tradeoff between inflation and
unemployment? Why or why not?

4. Suppose the Bank of Canada announced that it would pursue contractionary monetary policy
in order to reduce the inflation rate. Would the following conditions make the ensuing
recession more or less severe? Explain.
a. Wage contracts have short durations.
b. There is little confidence in the Bank of Canada’s determination to reduce inflation.
c. Expectations of inflation adjust quickly to actual inflation.