Table I The Aggregate-Demand Curve: Summary, Part 1

Why Does the Aggregate-Demand Curve Slope Downward?

1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on
consumption.
2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending
on investment.
3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which
stimulates spending on net exports.

Table I The Aggregate-Demand Curve: Summary, Part 2

Why Might the Aggregate-Demand Curve Shift?

1. Shifts Arising from Changes in Consumption: An event that causes consumers to spend more at
a given price level (a tax cut, a stock market boom) shifts the aggregate-demand curve to the
right. An event that causes consumers to spend less at a given price level (a tax hike, a stock
market decline) shifts the aggregate-demand curve to the left.
2. Shifts Arising from Changes in Investment. An event that causes firms to invest more at a given
price level (optimism about the future, a fall in interest rates due to an increase in the money
supply) shifts the aggregate-demand curve to the right. An event that causes firms to invest less
at a given price level (pessimism about the future, a rise in interest rates due to a decrease in
the money supply) shifts the aggregate-demand curve to the left.
3. Shifts Arising from Changes in Govemment Purchases: An increase in government purchases of
goods and services (greater spending on defense or highway construction) shifts the aggregate-
demand curve to the right. A decrease in government purchases on goods and services (a
cutback in defense or highway spending) shifts the aggregate demand curve to the left.
4. Shifts Arising from Changes in Net Exports: An event that raises spending on net exports at a
given price level (a boom overseas, speculation that causes an exchange rate depreciation) shifts
the aggregate-demand curve to the right. An event that reduces spending on net exports at a
given price level (a recession overseas, speculation that causes an exchange-rate appreciation)
shifts the aggregate-demand curve to the left.

Exercise (AD curve)

1. People suddenly become more concerned about saving for retirement

2. A stock market boom makes people wealthier and thus less concerned about saving
3. Governments cuts taxes, encouraging people to spend more

Ans:

1. People suddenly become more concerned about saving for retirement:

• Shift of the AD curve: Leftward shift

 • Explanation: If people save more, they spend less. Consumption is a major component of
aggregate demand. Therefore, increased saving leads to decreased consumption and shifts the
AD curve to the left.

2. A stock market boom makes people wealthier and thus less concerned about saving:

• Shift of the AD curve: Rightward shift

• Explanation: Increased wealth leads to increased consumption. As people feel wealthier, they
are more likely to spend more. This increased spending shifts the AD curve to the right.

3. Governments cut taxes, encouraging people to spend more:

• Shift of the AD curve: Rightward shift

• Explanation: Tax cuts increase disposable income, leaving consumers with more money to
spend. This increased spending shifts the AD curve to the right.

Exercise (AD curve)

1. Faster computers are invented, most firms decide to buy it

2. Firms are becoming pessimistic about future business conditions
3. Government announces new investment tax credit
4. Government increases money supply, which lowered the interest rate in the short run

Ans:

1. Faster computers are invented, most firms decide to buy it

• Shift of the AD curve: Rightward shift

• Explanation: This event increases investment (I), a key component of aggregate demand. Firms
investing in new technology boosts overall spending in the economy.

2. Firms are becoming pessimistic about future business conditions

• Shift of the AD curve: Leftward shift

• Explanation: Pessimistic firms reduce investment spending (I) due to uncertainty about future
returns. This decrease in investment spending shifts the AD curve to the left.

3. Government announces new investment tax credit

• Shift of the AD curve: Rightward shift

• Explanation: An investment tax credit incentivizes firms to invest more. This increase in
investment spending shifts the AD curve to the right.

4. Government increases money supply, which lowered the interest rate in the short run
 • Shift of the AD curve: Rightward shift

• Explanation: Lower interest rates make borrowing cheaper for both consumers and businesses.
This encourages increased consumption (C) and investment (I), shifting the AD curve to the
right.

Exercise (AD curve)

1. Recession in a foreign buyer country

2. Some international speculators are buying taka in the foreign currency market. Taka has appreciated
against US dollar.

Ans:

1. Recession in a foreign buyer country

• Shift of the AD curve: Leftward shift

• Explanation: A recession in a foreign buyer country leads to decreased demand for exports from
the domestic country. This reduction in net exports (exports minus imports) shifts the aggregate
demand curve to the left.

2. Some international speculators are buying taka in the foreign currency market. Taka has appreciated
against US dollar.

Ans:

• Shift of the AD curve: Leftward shift (in the long run)

• Explanation:

o Short-run: An appreciating currency can initially boost net exports as domestic goods
become cheaper for foreign buyers. This might lead to a temporary rightward shift of
the AD curve.

o Long-run: However, in the long run, a strong currency makes exports more expensive
and imports cheaper. This hurts net exports and shifts the AD curve to the left.
Additionally, a strong currency can reduce investment as domestic firms become less
competitive globally. Sources and related content
Table 2 Short-Run Aggregate-Supply Curve: Summary, Part 1

Why Does the Short-Run Aggregate-Supply Curve Slope Upward?

1. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, which causes
firms to hire fewer workers and produce a smaller quantity of goods and services.
2. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher than
desired prices, which depresses their sales and leads them to cut back production.
3. The Misperceptions Theory: An unexpectedly low price level leads some suppliers to think their
relative prices have fallen, which induces a fall in production.

Table 2 Short-Run Aggregate-Supply Curve: Summary, Part 2

Why Might the Short-Run Aggregate-Supply Curve Shift?

1. Shifts Arising from Changes in Labor: An increase in the quantity of labor available (perhaps due
to a fall in the natural rate of unemployment) shifts the aggregate supply curve to the right. A
decrease in the quantity of labor available (perhaps due to a rise in the natural rate of
unemployment) shifts the aggregate-supply curve to the left.
2. Shifts Arising from Changes in Capital: An increase in physical or human capital shifts the
aggregate-supply curve to the right A decrease in physical or human capital shifts the aggregate-
supply curve to the left.
3. Shifts Arising from Changes in Natural Resources: An increase in the availability of natural
resources shifts the aggregate-supply curve to the right. A decrease in the availability of natural
resources shifts the aggregate-supply curve to the left.
4. Shifts Arising from Changes in Technology: An advance in technological knowledge shifts the
aggregate-supply curve to the right. A decrease in the available technology (perhaps due I to
government regulation) shifts the aggregate-supply curve to the left.
5. Shifts Arising from Changes in the Expected Price Level: A decrease in the expected price level
shifts the short-run aggregate-supply curve to the right. An increase in the expected price level
shifts the short-run aggregate-supply curve to the left.

Table 3 Four Steps for Analyzing Macroeconomic Fluctuations

1. Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or
perhaps both).
2. Decide the direction in which the curve shifts.
3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output
and the price level in the short run.
4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy
moves from its new short-run equilibrium to its new long-run equilibrium.
Question answer

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 happens 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.

a. Long-Run Equilibrium

In a long-run equilibrium, the economy operates at its potential output level. This is where the
aggregate demand (AD) curve intersects both the short-run aggregate supply (SRAS) curve and the long-
run aggregate supply (LRAS)
1
curve.

graph showing AD, SRAS, and LRAS intersecting at a point

b. Short-Run Effects of a Stock Market Crash

A stock market crash reduces consumer wealth, leading to decreased consumption and investment. This
shifts the aggregate demand curve to the left (from AD1 to AD2).
previous graph with AD shifting to the left

In the short run, this causes:

• Output to decrease: The economy moves from the initial equilibrium (point A) to a new short-
run equilibrium (point B) with lower output.

• Price level to decrease: The decrease in demand leads to a lower price level.

• Unemployment rate to increase: Lower output typically implies higher unemployment.

c. Long-Run Adjustment: Sticky-Wage Theory

The sticky-wage theory suggests that nominal wages are slow to adjust to changes in the price level due
to contracts or other factors.

previous graph with SRAS shifting to the right

In the long run:

• Lower price level expectations: As the price level falls, workers and firms start to expect lower
prices in the future.

• Reduced real wages: With sticky nominal wages, the lower price level implies higher real wages
(wages relative to prices).

• Increased production: Firms find it more profitable to produce at the higher real wages, leading
to an increase in short-run aggregate supply (SRAS shifts right from SRAS1 to SRAS2).

• Return to potential output: The economy eventually returns to its potential output level (point
C) with a lower price level.

Role of Expected Price Level:

The expected price level plays a crucial role in the long-run adjustment. Lower expected prices lead to
lower nominal wage demands, making production more profitable and shifting the SRAS curve to the
right. This process continues until the economy returns to its potential output level with a lower price
level.
2. Explain whether each of the following events increases, decreases, or has 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.

Ans

a. The United States experiences a wave of immigration.

• Increases long-run aggregate supply. Immigration can increase the labor force, leading
to more production potential.

b. Congress raises the minimum wage to $15 per hour.

• No effect on long-run aggregate supply. While a minimum wage increase can impact
short-run costs, in the long run, wages are flexible and adjust to market forces.

c. Intel invents a new and more powerful computer chip.

• Increases long-run aggregate supply. Technological advancements like this boost

productivity and increase potential output.

d. A severe hurricane damages factories along the East Coast.

• Decreases long-run aggregate supply. The destruction of capital (factories) reduces the
economy's productive capacity.

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 aggregate supply 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 equilibrium 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
with nominal wages at point B? How do nominal wages at point A compare with nominal wages at point
C?

e. According to the sticky-wage theory of aggregate supply, how do real wages at point A compare

with real wages at point B? How do real wages at point A compare with 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?

Ans:

a. Initial Long-Run Equilibrium (Point A)

At point A, the economy is in long-run equilibrium. Aggregate demand (AD1), short-run aggregate supply
(SRAS1), and long-run aggregate supply (LRAS) intersect.

graph showing AD1, SRAS1, and LRAS intersecting at point A

b. Short-Run Effects of a 5% Money Supply Increase (Point B)

An increase in the money supply shifts the aggregate demand curve to the right (from AD1 to AD2). This
leads to a new short-run equilibrium at point B, with higher output and a higher price level.

Opens in a new window

pressbooks.senecapolytechnic.ca

previous graph with AD shifting to the right to AD2, intersecting SRAS1 at point B

c. New Long-Run Equilibrium (Point C)

In the long run, the higher price level leads to:

• Increased expected price level: Workers and firms anticipate higher prices in the future.

• Higher nominal wages: Workers demand higher wages to maintain their real purchasing power.

• Reduced profitability: Higher nominal wages reduce firms' profitability, leading to decreased
production.

This process continues until the short-run aggregate supply curve shifts left (from SRAS1 to SRAS2),
returning the economy to its potential output level at point C, but with a higher price level.

previous graph with SRAS shifting to the left to SRAS2, intersecting AD2 and LRAS at point C

d. Nominal Wages

• Point A vs. Point B: Nominal wages remain unchanged in the short run due to sticky wages.

• Point A vs. Point C: Nominal wages are higher at point C due to adjustments in the long run.

e. Real Wages

• Point A vs. Point B: Real wages are lower at point B because the price level has increased while
nominal wages are sticky.

• Point A vs. Point C: Real wages are the same at points A and C because both the price level and
nominal wages have increased proportionally in the long run.

f. Money Neutrality

This analysis is consistent with the proposition that money has real effects in the short run but is neutral
in the long run.

• Short Run: The increase in the money supply leads to a temporary increase in output and a
decrease in real wages, indicating real effects.

• Long Run: The economy returns to its potential output level, and real wages are unchanged,
suggesting money neutrality.
 5. In 1939, with the U.S. economy not yet fully recovered from the Great Depression, President
Franklin Roosevelt proclaimed that Thanksgiving would fall a week earlier than usual so that the
shopping period before Christmas would be longer. (The policy was dubbed "Franksgiving.")
Explain what President Roosevelt might have been trying to I achieve, using the model of
aggregate demand and aggregate supply.

Ans: Understanding Franksgiving

President Roosevelt's decision to move Thanksgiving a week earlier in 1939 was likely an attempt to
stimulate consumer spending and boost aggregate demand. Here's how we can analyze this using the
aggregate demand and aggregate supply model:

The Problem: The Great Depression

• Low Aggregate Demand: The Great Depression was characterized by a significant decrease in
aggregate demand. This means that consumers were spending less, businesses were investing
less, and the overall demand for goods and services in the economy was weak.

• Economic Stagnation: Low aggregate demand led to reduced production, high unemployment,
and slow economic growth.

Roosevelt's Solution: Shifting Thanksgiving

By moving Thanksgiving earlier, Roosevelt aimed to:

1. Extend the Holiday Shopping Season: A longer shopping period between Thanksgiving and
Christmas would give consumers more time to shop and potentially increase their overall
spending.

2. Boost Consumer Confidence: The anticipation of a longer holiday shopping season might have
encouraged consumers to spend more, even if they weren't planning on making large
purchases.

The Impact on Aggregate Demand

• Increased Consumption: If consumers spent more during the extended shopping season, it
would directly increase consumption (C), a key component of aggregate demand.

• Potential for Increased Investment: If businesses anticipated higher consumer spending, they
might increase investment (I) to meet the expected demand, further boosting aggregate
demand.

Visualizing the Effect

In the aggregate demand and aggregate supply model, this shift in consumer behavior would be
represented by a rightward shift of the aggregate demand curve. This shift would lead to:

• Increased Output: Higher aggregate demand would encourage businesses to produce more
goods and services.

• Increased Employment: Increased production would likely lead to higher employment levels.
 • Potential Increase in Price Level: While the primary goal was to increase output and
employment, a potential side effect could be a slight increase in the overall price level.

Important Note:

While the idea behind Franksgiving was sound, its actual impact on the economy is debatable. Some
argue that it had little effect, while others believe it contributed modestly to economic recovery.
However, the underlying principle of using fiscal policy (in this case, indirectly through a change in
consumer behavior) to stimulate aggregate demand remains relevant in economic theory.

7. The economy begins in long-run equilibrium. Then one day, the president appoints a new Fed chair.
This new chair 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 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 would this change in profitability affect the short-run aggregate-supply curve?

e. If aggregate demand is held constant, how would this shift in the aggregate-supply curve affect the
price level and the quantity of output produced?

f. Do you think appointing this Fed chair was a good decision?

Ans:

a. How would this news affect the price level that people expect to prevail?

The new Fed chair’s view that inflation is "not a major problem" would likely lead people to expect
higher future price levels (higher inflation). This is because people might believe the Fed will tolerate
higher inflation without taking action to control it.

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?

If people expect higher inflation, workers will demand higher nominal wages to preserve their
purchasing power. Firms, anticipating higher costs due to inflation, might agree to higher wages in their
labor contracts to maintain labor supply.

c. How would this change in the nominal wage affect the profitability of producing goods and services at
any given price level?
Higher nominal wages increase production costs for firms. This reduces the profitability of producing
goods and services at any given price level. Firms may scale back production as a result.

d. How would this change in profitability affect the short-run aggregate supply curve?

The increase in nominal wages shifts the short-run aggregate supply (SRAS) curve to the left. This is
because higher wages make production more expensive, reducing the quantity of goods and services
supplied at any given price level.

e. If aggregate demand is held constant, how would this shift in the aggregate-supply curve affect the
price level and the quantity of output produced?

1. Price level: The leftward shift of the SRAS curve causes the price level to rise, as there is now less
supply at each price point.

2. Quantity of output: Output (real GDP) falls, as higher production costs discourage firms from
maintaining previous output levels.

This scenario results in stagflation: higher prices (inflation) and lower output.

f. Do you think appointing this Fed chair was a good decision?

This is subjective and depends on perspective. Here are arguments for and against:

Arguments Against:

• If the Fed chair's tolerance for inflation leads to a rise in inflation expectations, it could result in
stagflation (higher prices and lower output), harming the economy.

• Stability in inflation expectations is key for economic growth, and this policy risks disrupting that
stability.

Arguments For:

• The Fed chair's policies might focus on encouraging higher employment or output by tolerating
moderate inflation, which can be beneficial in an underperforming economy.

• If inflation expectations were too low previously, her policies could help avoid deflation risks.

In general, tolerating higher inflation without a corresponding focus on output or employment growth
could harm economic stability. Most economists would likely argue this is a risky approach.

Let me know if you'd like graphs or further clarification!

8. Explain whether each of the following events shiftsthe 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 ofl below-freezing temperatures.

c. Increased job opportunities overseas cause many people to leave the country.

Ans: a. Households decide to save a larger share of their income.

• Shifts: Aggregate Demand Curve

• Direction: Leftward Shift

Explanation: When households save more, they consume less. Consumption is a major component of
aggregate demand. Therefore, an increase in the savings rate leads to a decrease in consumption and a
leftward shift of the aggregate demand curve.

graph showing a leftward shift of the aggregate demand curve

b. Florida orange groves suffer a prolonged period of below-freezing temperatures.

• Shifts: Short-Run Aggregate Supply Curve

• Direction: Leftward Shift

Explanation: A freeze that damages orange groves reduces the supply of oranges, a key input for many
food products. This supply shock increases the cost of production for various goods, leading to a
decrease in short-run aggregate supply.
graph showing a leftward shift of the shortrun aggregate supply curve

c. Increased job opportunities overseas cause many people to leave the country.

• Shifts: Short-Run Aggregate Supply Curve and Long-Run Aggregate Supply Curve

• Direction: Leftward Shift for both

Explanation: Emigration reduces the labor force, a key factor of production. This decreases both the
short-run and long-run productive capacity of the economy, shifting both the short-run and long-run
aggregate supply curves to the left.

Opens in a new window

pressbooks.senecapolytechnic.ca

graph showing a leftward shift of both the shortrun and longrun aggregate supply curves

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.

Ans:

a. Stock Market Decline

• Short-Run: Reduced consumer wealth leads to decreased consumption, shifting aggregate

demand left. Output falls, and the price level decreases.

• Long-Run: In the long run, wages and prices adjust. The short-run aggregate supply curve shifts
right, returning output to its potential level but with a lower price level.

b. Increased Government Spending

• Short-Run: Government spending is a component of aggregate demand. Increased spending

shifts aggregate demand right, raising output and the price level.

• Long-Run: The higher price level leads to increased expected prices and wage demands. The
short-run aggregate supply curve shifts left, returning output to its potential level but with a
higher price level.

c. Technological Improvement

• Short-Run: Increased productivity shifts the short-run aggregate supply curve right, increasing
output and lowering the price level.

• Long-Run: The long-run aggregate supply curve also shifts right due to the permanent increase
in potential output. Output remains higher, and the price level may continue to fall or stabilize
at a lower level.

d. Foreign Recession

• Short-Run: Reduced foreign demand for U.S. goods decreases net exports, a component of
aggregate demand. Aggregate demand shifts left, lowering output and the price level.

• Long-Run: Similar to the stock market decline, in the long run, wages and prices adjust. The
short-run aggregate supply curve shifts right, returning output to its potential level but with a
lower price level.

10. Suppose firms become 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 long-run aggregate-supply curve? Explain.

Ans:

a. Short-Run Effect of Investment Boom

• Increased Investment: Firms' optimism leads to increased investment spending (I), a

component of aggregate demand.
• Shift in Aggregate Demand: This increased investment shifts the aggregate demand
curve to the right, from AD1 to AD2.
• New Short-Run Equilibrium: The economy moves from the initial equilibrium (point
A) to a new short-run equilibrium (point B) with higher output (Y2) and a higher price
level (P2).

Opens in a new window www.chegg.com

graph showing a rightward shift of the aggregate demand curve from AD1 to AD2, with
the new equilibrium at point B

Why Output Changes in the Short Run:

In the short run, prices are sticky. When aggregate demand increases, firms respond by
increasing production to meet the higher demand, leading to increased output.

b. Long-Run Adjustment

• Increased Price Level Expectations: The higher price level in the short run leads to
increased expected prices.
• Higher Wages: Workers demand higher wages to maintain their real purchasing power.
• Reduced Profitability: Higher wages reduce firms' profitability, leading to decreased
production.
• Shift in Short-Run Aggregate Supply: The short-run aggregate supply curve shifts left
from SRAS1 to SRAS2.
 • New Long-Run Equilibrium: The economy reaches a new long-run equilibrium at point
C, with the same output level as before (Y1) but a higher price level (P3).

previous graph with the shortrun aggregate supply curve shifting left from SRAS1 to
SRAS2, with the new longrun equilibrium at point C

Why Output Returns to the Original Level:

In the long run, wages and prices adjust. The higher price level leads to higher wages, reducing
firms' profitability and incentivizing them to reduce production until the original output level is
restored.

c. Effect on Long-Run Aggregate Supply

The investment boom can potentially shift the long-run aggregate supply curve to the right. This
is because increased investment in capital equipment can lead to increased productivity and
potential output in the long run. However, this effect is not captured in the simplified model used
in this analysis.

Opens in a new window

pressbooks.senecapolytechnic.ca
previous graph with the longrun aggregate supply curve shifting right from LRAS1 to LRAS2

Key Points:

• In the short run, an investment boom increases output and the price level.
• In the long run, output returns to its original level, but the price level remains higher.
• The investment boom can potentially increase potential output in the long run, shifting
the long-run aggregate supply curve to the right.