Back to study guide for the third exam          Last revised: 03/30/2009

Answers to the Review Questions from Macroeconomics: Aggregate Supply and Aggregate Demand

1.The quantity of real GDP supplied depends on the quantity of labor, capital, and level of technology.

2. When there is full employment, the economy is producing potential GDP.

3. The macroeconomic short run is the period of time during which real GDP can differ from potential real GDP. Adjustments are being made so that real GDP is moving toward potential real GDP. In the macroeconomic short run, employment can differ from full employment. The macroeconomic long run is the period of time long enough that all adjustments have been made so that real GDP equals potential GDP and there is full employment.

In general, the aggregate supply of goods and services is the total amount of final goods and services supplied by all the firms in the economy. Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential real GDP. The long-run aggregate supply curve (LAS ) is vertical at potential real GDP, which indicates that the long-run aggregate supply is independent of the price level. The short-run aggregate supply, SAS, is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate and all other influences on production plans remain constant. Along the SAS curve input prices remain constant. The short-run aggregate supply curve slopes upward, indicating that in the short run a higher price level increases the quantity of real GDP supplied.

4. The key distinction between the short-run aggregate supply and the long-run aggregate supply involves resource prices. Along the SAS curve resource prices remain constant; along the LAS curve resource prices have adjusted to their final equilibrium. Thus a movement along the SAS curve shows what happens to the quantity supplied when the price of output changes and resource prices remain constant. As a result, employment can be above or below the full-employment level. However, the LAS curve illustrates what happens to the quantity supplied when the prices of output change and the prices of all resources have also changed to their new equilibrium level. Therefore a movement along the LAS curve reflects both output and resource price changes at full employment.

5. Category 1: No factors listed affect the long-run aggregate supply curve that do not also affect the short-run aggregate supply curve.

Category 2: Factors (b) and (d) (a rise in the money wage rate and an increase in both the money wage rate and price level) shift the SAS curve leftward.

Category 3: Factor (a) (an increase in potential real GDP) shifts both the SAS and LAS curves rightward.

Category 4: Factor (d) (an increase in both the money wage rate and price level by the same percentage) causes a movement along the LAS curve.

Category 5: Factor (c) (an increase in the price level) causes a movement along the SAS curve.

Category 6: No factors listed cause movements along both the LAS and SAS curves.

6. The difference between "aggregate demand" and the "quantity of real GDP demanded" is the same as the difference between "demand" and "quantity demanded." Aggregate demand shows how many final goods and services are demanded by all sectors of the economy at every possible price level. However, the aggregate quantity demanded shows how many final goods and services are demanded at a particular price level. Finally, aggregate planned expenditure equals the quantity of real GDP demanded.

7. a. The quantity of money does affect aggregate demand.

b. Interest rates do affect aggregate demand.

c. Technological change does not affect aggregate demand. Technological change shifts the aggregate supply curve and thereby causes a change in the aggregate quantity demanded.

d. Human capital does not affect aggregate demand. Human capital shifts the aggregate supply curve and thereby causes a change in the aggregate quantity demanded.

8. Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity supplied. In terms of the AD/AS diagram, short-run macroeconomic equilibrium is the point at which the aggregate demand curve crosses the short-run aggregate supply curve.

9. The distinction between an equilibrium with a recessionary gap and a full-employment equilibrium results because, in the short run, macroeconomic equilibrium occurs where the AD curve crosses the short-run AS curve, not necessarily where it intersects the long-run AS curve. If the AD curve intersects the SAS curve at a level of output less than full employment, there is a below full-employment equilibrium, that is, unemployment is above its natural rate. This equilibrium is illustrated in Figure 8.11(a) on page 165 of the text, but it is a short-run equilibrium only. The prices of resources adjust so that the SAS curve shifts, thereby changing the equilibrium level of GDP. Eventually, resource prices adjust to their long-run equilibrium level, and at that time the AD curve crosses the SAS curve where it crosses the LAS curve. Hence at that time the macroeconomic equilibrium is at full employment.

10. The effect of an increase in the quantity of money differs between the short run and the long run. In Figure 8.12(a) on page 166, an increase in the quantity of money shifts the AD curve fromto As a result, in the short run the economy moves along the short-run aggregate supply curveto a new equilibrium, with a higher level of real GDP ($7.5 trillion versus the initial level of $7 trillion) and a higher price level (115 compared to 110). Real GDP exceeds the full-employment level of GDP, so this situation is an above full-employment equilibrium.

The short-run equilibrium cannot persist. In the long run, resource prices adjust to the higher price level, as illustrated in Figure 8.12(b) on page 166. The higher resource prices cause the short-run aggregate supply curve to shift leftward, to Thus in the long run the level of real GDP returns to its initial, full-employment level ($7 trillion in the diagram), and the price level moves to a new, permanently higher level (125 in the figure).

11. The effect of a higher oil price is illustrated in Figure 8.13 on page 167, where the initial equilibrium is at potential real GDP of $7 trillion and price level of 110. The higher price of oil shifts the short-run aggregate supply curve leftward, from to As a result, output decreases from $7 trillion to $6.5 trillion and the price level rises from 110 to 120.

12. The primary factors generating growth in real GDP for the United States include growth in the labor force, accumulation of new capital, and advances in technology. All these factors shift the long-run aggregate supply curve rightward and make economic growth possible.

Inflation is primarily the result of one factor: increases in the quantity of money. Persistent increases in the quantity of money result in persistent increases in the aggregate demand curve. In turn, this condition causes persistent increases in the price level, that is, inflation.

Business cycles arise because changes in the short-run aggregate supply and aggregate demand curves do not occur at a steady pace. If the aggregate demand and short-run aggregate supply curves moved steadily, GDP growth and inflation would evolve smoothly over the years. However, that is not the case: In some years, growth in AD outstrips growth in SAS. As a result, GDP and the price level both boom. In other years, the SAS curve may shift leftward, causing GDP to fall and prices to rise rapidly. Or, in other years, the SAS may grow more rapidly than AD, with rapidly rising GDP and falling prices the result. All these discrepancies in the growth of the AD and SAS curves create business cycles.

13. Demand and supply in the labor market determine the equilibrium level of employment and the equilibrium real wage rate in a manner identical to how demand and supply in any market determine the equilibrium quantity and price. Figure 8.11 (page180) shows demand and supply curves for the labor market. At any real wage higher than the equilibrium real wage, $15 in the figure, the surplus of labor creates downward pressure on the real wage so that the real wage falls to its equilibrium level. Similarly, at any real wage below the equilibrium, the shortage of labor puts upward pressure on the real wage. In this case, the real wage rises to its equilibrium level. Only at the equilibrium real wage rate is there no tendency for the real wage rate to change, so this real wage rate is the wage rate that will persist in the market. At this real wage, the quantity of labor supplied equals the quantity demanded and hence is the equilibrium amount, 215 billion hours.

14. Since 1960 real wages and the level of employment have increased. The demand curve for labor has shifted rightward because of increases in workers’ productivity. Simultaneously, the supply curve of labor also has shifted rightward because of growth in the working-age population. The shift in the demand curve has exceeded the shift in the supply curve, so that the real wage rate has increased.

15. Assuming that the story told by the bias-adjusted CPI is incorrect (that is, assuming that real wages actually did slow) the major reason that the growth rate of the average real wage slowed was the productivity growth slowdown. During the 1970s and 1980s, productivity growth slowed because of high energy prices. Real wage growth has slowed and even fallen within particular segments of the economy because of structural change. For instance, the real wage in manufacturing generally has fallen since 1973, primarily because of structural changes that have decreased the demand for U.S. manufacturing workers.

16. The three reasons for the existence of unemployment are:

bulletJob search — workers looking for jobs.
bulletJob rationing — when employed workers are paid a wage that creates an excess supply of labor. (Job rationing can occur because of efficiency wages, insider–outsider reasons, or the minimum wage.)
bulletSticky money wages — if the real wage rate is above its equilibrium amount and money wages do not rapidly change to restore the real wage to the equilibrium, an excess supply of labor and hence unemployment exist.

 

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