Deck 12: A: Aggregate Demand and Aggregate Supply

Question 1

Suppose that a hypothetical economy has the following relationship between its real domestic output and the input quantities necessary for producing that level of output. (a) What is the level of productivity in this economy?
(b) What is the unit cost of production if the price of each input is $2.00?
(c) If the input price decreases from $2 to $1.50, what is the new per unit cost of production? What impact would this have on the short-run aggregate supply curve?
(d) Suppose that instead of the input price decreasing, the productivity had increased by 25%.What will be the new unit cost of production? What impact would this change have on the short-run aggregate supply curve?

Answer 1

(a) The level of productivity is 2 output units per input unit.
(b) Since productivity is 2 units of output per input unit and each unit of input costs $2, the cost of production per unit of output is $1 ($2/2 units).
(c) The unit cost will decline from $1 per unit to $.75 per unit.The short-run aggregate supply curve would shift rightward as a result of the decrease in input price.
(d) If productivity rose by 25%, then there would be 1.25 units produced per $1 of input costs.The unit cost of production would be $.80 per unit.The short-run aggregate supply curve would shift to the right.

Question 2

Explain the three reasons given for the downward slope of the aggregate demand curve.

Answer 2

The three reasons given are the real-balances effect, the interest-rate effect, and the foreign trade effect.
The real-balances effect refers to the idea that a higher price level will reduce the purchasing power of the population's accumulated financial assets.Because of the decline in value of such assets, people will feel poorer and will reduce their spending.Conversely, as the price level falls the opposite will occur.
The interest-rate effect assumes that as the price level rises so will interest rates, and rising interest rates will reduce certain kinds of spending such as consumption spending on durable goods and investment spending.
The foreign trade effect assumes that if the price level rises in Canada relative to that in foreign countries, Canadians will increase spending on imports at the expense of domestically produced goods and services, and foreigners will reduce purchases of Canadian goods.In other words, net exports decline.

Question 3

Suppose the aggregate demand and short-run aggregate supply schedules for a hypothetical economy are as shown below:
(a) What will be the equilibrium price and real output level in this hypothetical economy? Is this level of real GDP also the full-employment level of output? Explain.(b) Why won't a price level of 110 be the equilibrium price level? Why won't a price level of 130 index be the equilibrium price level?
(c) Suppose aggregate demand increases by $400 billion at each price level.What will be the new equilibrium price and output levels?
(d) What factors might cause aggregate demand to increase?

Answer 3

(a) The equilibrium real GDP is $800 billion and the equilibrium price level is 120.There is not enough information given to determine whether or not this is the full-employment level of real GDP.
(b) At a price level of 110, the aggregate demand would exceed aggregate supply and prices would be bid up.At a price level of 130, short-run aggregate supply would exceed aggregate demand and the resulting surpluses would cause prices to be bid downward toward the equilibrium level of 120.
(c) The new equilibrium price level is 130 and the new equilibrium real GDP is $1,000 billion.
(d) Aggregate demand would increase if any of the four basic determinants of aggregate demand-consumer spending, investment, government expenditures, and net export spending-increased.An increase in consumer wealth, increased expectations of future inflation, a decline in household indebtedness, or decreased personal taxes would increase the consumer spending component of aggregate demand.Investment spending would increase as a result of lower interest rates, increased expectations of improved profits in the future, a decline in business taxes, new and improved technology, or a decline in excess capacity.Government spending might increase for a variety of reasons.Net export spending would increase as a result of improved economic conditions abroad or a depreciation in the Canadian dollar.

Question 4

Identify the ways in which each of the following determinants would have to change to cause a decrease in aggregate demand: consumer wealth, consumer expectations, business taxes, national income in countries abroad, exchange rates.

Question 5

Describe the change in short-run aggregate supply that should result from each of the following changes in determinants.Assume that nothing else is changing besides the identified change.(Use "Decrease" or "Increase.")
(a) A rise in the average price of inputs;
(b) An increase in worker productivity;
(c) Government antipollution regulations become stricter;
(d) A new subsidy program is enacted for new business investment in productive equipment;
(e) Energy prices decline.

Question 6

In the below diagram assume that the aggregate demand curve shifts from AD1 in year 1 to AD2 in year 2, only to fall back to AD1 in year 3. (a) Explain what will happen to the equilibrium price level and the equilibrium level of real GDP from year 1 to year 2.(b) Locate the new position in year 3 on the assumption that prices and wages are completely flexible downward.Label this position, Pb and GDPb for the price level and real GDP respectively.(c) Locate the new position in year 3 on the assumption that prices and wages are completely inflexible downward.Label this position, Pc and GDPc for the price level and real GDP respectively.

Question 7

Economists think of three different aggregate supply curves based upon the time frame of observation.Briefly describe each.

Question 8

The determinants of aggregate demand "determine" the location of the aggregate demand curve.Explain the four basic determinants of aggregate demand.

Question 9

What is the difference in the explanation of the shape of the aggregate demand curve and a single product demand curve? After all, both demand curves show an inverse relationship between price and quantity.

Question 10

What determines the equilibrium price level and the level of real GDP in the aggregate demand-aggregate supply (short-run) model?

Question 11

Suppose the aggregate demand and short-run aggregate supply schedules for a hypothetical economy are as shown below:
(a) What will be the equilibrium price and real output level in this hypothetical economy? Is this level of real GDP also the full-employment level of output? Explain.(b) Why won't a price level of 100 be the equilibrium price level? Why won't a price level of 110 index be the equilibrium price level?
(c) Suppose aggregate demand increases by $120 billion at each price level.What will be the new equilibrium price and output levels?
(d) What factors might cause aggregate demand to increase?
(e) Suppose short-run aggregate supply increases by $120 billion at each price level.What will be the new equilibrium price and output levels?

Question 12

List the three major determinants that can cause a shift in the short-run aggregate supply.

Question 13

How is the short-run aggregate supply curve sloped and why is it sloped this way?

Question 14

In the table below are aggregate demand and aggregate supply schedules. (a) Suppose in Year 1, aggregate demand is shown in columns (1) and (2) in the above table and short-run aggregate supply is shown in columns (1) and (4) in the above table.What will be the equilibrium level of real GDP and the equilibrium price level?
(b) Suppose in Year 2, aggregate demand changes and is now shown in columns (1) and (3).What will be the new equilibrium level of real GDP and the new equilibrium price level?
(c) Suppose in Year 3, aggregate demand changes and is now shown again in columns (1) and (2).What will be the new level of real GDP and the new price level if prices and wages are completely flexible downward?
(d) Suppose in Year 3, aggregate demand changes and is now shown again in columns (1) and (2).What will be the new level of real GDP and the new price level if prices and wages are completely inflexible downward?

Question 15

List four government tax or spending policy options that would shift the short-run aggregate supply curve rightward.

Question 16

What is the aggregate demand curve? What is the characteristic of its slope?

Question 17

List three events that would shift the short-run aggregate supply curve leftward.

Question 18

What is the effect on the multiplier when an increase in aggregate demand also causes the price level to rise?

Question 19

How is the immediate short-run aggregate supply curve sloped? Explain.

Question 20

How is the long-run aggregate supply curve sloped? Explain.

Question 21

Using the aggregate demand-aggregate supply (short-run) model, explain how the depreciation of the Canadian dollar in terms of foreign currencies would affect the economy.

Question 22

Explain the relationship between the aggregate expenditures model in graph (A) below and the aggregate demand model in graph (B) below where aggregate demand is shifting.

Question 23

Describe and explain what is meant by the ratchet effect.

Question 24

Some economists argue that it is easier to resolve demand-pull inflation than cost-push inflation.Use the aggregate demand-aggregate supply (short-run) model to explain this assertion.

Question 25

Explain the relationship between the aggregate expenditures model in graph (A) below and the aggregate demand model in graph (B) below.In other words, explain how points 1, 2, and 3 are related to points 1', 2', and 3'.

Question 26

Would increased downward price flexibility lead to less severe or more severe recessions? Explain.

Question 27

Why does aggregate demand shift outward by a greater amount than the initial change in spending?

Question 28

How can an economy already at full-employment expand without igniting inflation? Explain.

Question 29

Using the aggregate demand-aggregate supply (short-run) model, explain how a reduction in business taxes would affect the economy.

Question 30

What are five reasons for the downward price-level inflexibility, especially as it pertains to wages and prices?

Question 31

Using the aggregate demand-aggregate supply (short-run) model, explain the impact of the public's expectations of severe inflation on real GDP and the price level.

Question 32

Suppose an economic advisor to the Prime Minister recommended a personal income tax increase.Indicate the expected effects on aggregate demand and on short-run aggregate supply.

Question 33

Is the downward price inflexibility applicable to today's economy? Why or why not?

Question 34

Differentiate between "demand-pull" and "cost-push" inflation using the aggregate demand-aggregate supply (short-run) model.

Question 35

How can the aggregate demand curve be derived from the aggregate expenditures model?