Deck 8: The Aggregate Demand-Aggregate Supply Model

Question 1

Canada is the largest trading partner of the U.S.Suppose the U.S.economy keeps growing.What will happen to the AD curve for Canada?

Answer 1

As the U.S.economy keeps growing people in the U.S.will buy more things from Canada.This will result in a rightward shift (an increase) in the Canadian AD curve.

Question 2

If an economist argues that equilibrium output differs from potential output, is that economist most likely a Keynesian or Classical economist?

Answer 2

She is most likely a Keynesian economist; a Classical economist would be much more likely to see equilibrium output equal to potential output.

Question 3

In the standard supply demand model, a fall in price brings a market with a shortage of quantity demanded into equilibrium by increasing the quantity demanded and decreasing the quantity supplied.Why doesn't that work in the aggregate?

Answer 3

There are a number of reasons why.First, in the standard supply-demand model, in which the market is a small component of the aggregate market, the price on the y-axis is a relative price, and it is a fall in that relative price that brings the market into equilibrium.In the aggregate, there is no relative price-the price of all goods rise or fall, so the standard arguments about demanders substituting one good for another doesn't hold.So there is no reason to argue that a fall in the price level will solve the problem of an excess quantity of aggregate demand.Further, that fall in price level doesn't occur because social pressures prevent firms from lowering wages and prices much in many markets; instead they decrease production and lay off workers.
A second reason is that aggregate demand and aggregate supply are not independent of one another.When firms in the aggregate attempt to solve the problem of excess supply by decreasing production and laying off workers, another problem, which the aggregate market faces that the standard supply-demand model doesn't, arises-the problem of interdependent aggregate supply and demand.As firms lay off workers, those workers buy fewer products, which decreases the aggregate demand, which leads firms to lay off more workers.The result can be a cumulative process of falling output.It is that process that Keynes highlighted in his work.
A third reason a fall in the price level will not solve the problem of excess aggregate supply relates to asset prices.In our economy, borrowing is based on collateral tied to asset prices.When the goods price level falls, the asset price level is also likely to fall, which will make people feel poorer, causing them to buy less.It will also cause lenders to ask for their loans to be paid back, which can cause borrowers to default on loans, undermining business and consumer confidence.The result can be a depression.

Question 4

According to Keynes there is a difference between equilibrium income and potential income.Explain this difference.

Question 5

What was the Classical economists' suggestion for ending unemployment during the Great Depression?

Question 6

Keynes did not agree with the way the Classical economists described the workings of the economy.What was the essence of his thinking?

Question 7

What are the effects of an increase in aggregate demand (AD) in the short run and the long run? What is the effect of an increase in the short run aggregate supply (SAS)? What is the effect of an increase in Long run Aggregate Supply (LAS)?

Question 8

Imagine you are the chief economist on the President's Council of Economic Advisers.The President has asked you to develop a policy that she can announce during her upcoming State of the Union Address.Your staff knows the President has a fondness for the SAS-AD model.Unfortunately, you can't you give her solid policy prescriptions based on that model because you do not know the location of the LAS curve.Explain why that is a serious problem.

Question 9

What is the difference, in terms of the time frame of analysis, between Classicals and Keynesians?

Question 10

Give two examples of expectations that would tend to cause the aggregate demand curve to rise (shift out to the right).

Question 11

Describe two ways in which the macro AS/AD model differs from the micro supply and demand model.

Question 12

Why would the U.S.be concerned about economies in other parts of the world, particularly Japan, Western Europe, Canada, and Mexico, having recessions?

Question 13

Explain why the long-run aggregate supply (LAS) curve is vertical.What determines the position of the LAS curve?

Question 14

Explain the difference between the long run and short-run views of saving.

Question 15

What does aggregate demand management mean?

Question 16

If the price level had more flexibility, would recessions and depressions be less likely?

Question 17

The shape of the short-run aggregate supply (SAS) curve reflects two different types of microeconomic markets (auction markets and the posted price markets).How is the price level linked to the level of output in each market? List five factors that might cause an upward shift of the SAS curve.

Question 18

What is the paradox of thrift?

Question 19

What is the key insight of the Keynesian AS/AD model, and what implication does this insight have for policy?

Question 20

Why might we expect the AD curve to be vertical?

Question 21

For each of the following "quotes" from The Wall Street Journal, draw a picture to show how the AD curve will shift.Label your original curve AD₀ and your new curve AD₁.
(a) "The value of the US dollar rose about 50% against the yen and 20% against the mark."
(b) "The Dow Jones Industrials closed above 25,000 for the first time."
(c) "Federal investment in civilian capital and infrastructure, education, and research and development is falling."

Question 22

In 2001, the U.S.economy suffered a mild recession.As a result, the Fed implemented expansionary monetary policy several times, and expanded the money supply to stimulate the economy.Explain the intention of such monetary policy.

Question 23

Suppose the economy is in an inflationary gap, as illustrated by point A in the diagram below: Suppose that everyone knows that inflationary gaps lead to cost pressures that will eventually result in the price level rising.Since people expect the price level to rise soon, suppose they increase their buying now (before prices rise).Demonstrate graphically and explain verbally how this will complicate the economy's adjustment story described in the text.

Question 24

Demonstrate graphically and explain verbally a recessionary gap.Describe two solutions for closing the gap.

Question 25

What factors shift the short-run aggregate supply (SAS) curve? Explain the impact of changes in each factor on the SAS curve.

Question 26

Consider the following diagram Demonstrate graphically and explain verbally the impact of a decrease of 50 in government spending on the AD curve in the diagram when the multiplier is 3.

Question 27

Assuming the economy is in long-run equilibrium, using an AS/AD diagram, demonstrate graphically and explain verbally the long-run impact on the price level and real output of an expectation by business executives of a recession in the near future.

Question 28

What is deflation? What could deflation do during a recession?

Question 29

Demonstrate graphically and explain verbally the case of an inflationary gap.Describe the forces in the economy that will result in the gap closing itself.

Question 30

Describe two distinct and opposing effects that a fall in interest rates (that are not caused by changes in the price level) could have on the AS/AD model.

Question 31

What are the three ways that falling asset prices can affect aggregate demand?

Question 32

Demonstrate graphically and explain verbally the role the multiplier effect has in the shape of the aggregate demand curve.

Question 33

Using an AS/AD diagram, demonstrate graphically and explain verbally the short-run impact on the price level and real output of an increase in the labor productivity schedule.

Question 34

Suppose that in order to win voter support for reelection, an incumbent President pushes a tax cut through Congress.What impact will this have on the AD curve?

Question 35

What are feedback effects, and how does the AS/AD model incorporate them?

Question 36

Demonstrate graphically and explain verbally the comparison of the impact of a drop in the price level on the shape of the aggregate demand curve when the multiplier effect is positive to when it is zero.

Question 37

Explain why the long-run aggregate supply (LAS) curve is vertical.

Question 38

How might feedback effects cause a fall in housing prices (like the one that set off the crisis in the U.S.economy in 2008) to cause a worse result than the one predicted by the standard AS/AD model?

Question 39

Why is the short-run aggregate supply (SAS) curve upward sloping?

Question 40

Explain what will happen to the SAS curve if productivity increases.

Question 41

Explain verbally and demonstrate graphically how in an AS/AD model with dynamic feedback effects, a decline in the price level can lead to a vicious downward spiral.