ECO 202 WK5 QUIZ Aggregate Demand and Supply PDF

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Wk 5 Quiz on chapters 29 and 30 inflation. Aggregate Demand and Supply...

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ECO 202 WK5 QUIZ 1 . Explaining short-run economic fluctuations

Most economists believe that real economic variables and nominal economic variables behave independently of each other in the long run. For example, an increase in the money supply, a

nominal

nominal

variable, will cause the price level, a

variable, to increase but will have no long-run effect on the quantity of goods and

services the economy can produce, a

real

variable. The notion that an increase in the quantity

of money will impact the price level but not the output level is known as

monetary neutrality

.

Points: 1/1 Close Explanation Explanation: Real variables measure quantities of goods and services, such as the quantity of a particular good or service produced in an economy or the number of units of one good a unit of another good can buy. Nominal variables, such as the quantity of money or the price level, are measured in terms of dollars. Monetary neutrality is the proposition of classical macroeconomic theory that changes in the money supply affect nominal variables but not real variables. Thus, an increase in the money supply will cause the price level and nominal wages to increase proportionately, but real variables, such as the quantity of output, employment, real wages, and real interest rates, will be unaffected. Most economists accept monetary neutrality as a description of how the economy works in the long run, but not in the short run. In the short run, however, most economists believe that real and nominal variables are intertwined. Economists use the model of aggregate demand and aggregate supply to examine the economy's short-run fluctuations around the long-run output level. The following graph shows an incomplete short-run aggregate demand (AD) and aggregate supply (AS) diagram—it needs appropriate labels for the axes and curves. You will identify some of the missing labels in the questions that follow. VERTICAL AXISHORIZONTAL AXISAD

AS

The vertical axis of the aggregate demand and aggregate supply model measures the overall

.

price level Points: 1/1

The aggregate

supply

curve shows the quantity of goods and services that firms produce and

sell at each price level. Points: 1/1 Close Explanation Explanation: The following graph shows the short-run model of aggregate demand and aggregate supply. The price level, a nominal variable, is on the vertical axis, and the quantity of output, a real variable, is on the horizontal axis. The downward-sloping aggregate demand curve shows the quantity of output that governments, consumers, business firms, and foreign customers wish to buy at each price level. The upward-sloping aggregate supply curve shows the quantity of output that firms produce and sell at each price level. PRICE LEVELQUANTITY OF OUTPUTAggregate Demand

Aggregate Supply

2 . Why the aggregate demand curve slopes downward

The following graph shows the aggregate demand (AD) curve in a hypothetical economy. At point A, the price level is 140, and the quantity of output demanded is $300 billion. Moving down along the aggregate demand curve from point A to point B, the price level falls to 120, and the quantity of output demanded rises to $500 billion. 010020030040050060070080017016015014013012011010090PRICE LEVELOUTPUT (Billions of dollars)AD

AB

As the price level falls, the cost of borrowing money will

demanded to

Points:

rise

. This phenomenon is known as the

fall

, causing the quantity of output

interest rate

effect.

1/1 Close Explanation Explanation: If the price level falls, people will need less money to carry out day-to-day transactions. As people demand less money, the cost of borrowing money—the interest rate—will fall (assuming that the quantity of money in the economy is fixed). As a result, business investment speeds up, leading to an increased demand for domestic output. This is known as the interest rate effect of a change in the price level. Note that a lower interest rate increases not only investment spending, but also consumer spending, as people will want to save less. So, at a lower interest rate, business investment increases and household saving decreases, leading to an increased demand for domestic output. Additionally, as the price level falls, the impact on the domestic interest rate will cause the real value of the dollar to fall in foreign exchange markets. The number of domestic products purchased

by foreigners (exports) will therefore

rise

domestic consumers and firms (imports) will

the quantity of domestic output demanded to

exchange rate

, and the number of foreign products purchased by

fall

rise

. Net exports will therefore

rise

, causing

. This phenomenon is known as the

effect.

Points: 1/1 Close Explanation Explanation: When an economy's price level falls, consumers require less money to purchase a given basket of goods and services, so that money demand falls, causing the domestic interest rate to fall. Investors respond to lower domestic interest rates by seeking higher returns abroad. As domestic investors attempt to convert dollars into foreign currency to buy foreign assets, the supply of dollars increases in the market for foreign-currency exchange, and the real value of the dollar falls. When each dollar buys fewer units of foreign currencies, foreign goods become more expensive than domestic goods. Because of dollar depreciation, foreigners find domestic goods to be relatively inexpensive. Exports of domestic goods to foreigners therefore rise, while domestic imports of foreign

goods fall. Net exports (exports minus imports) therefore rise, leading to a rise in the quantity of domestic output demanded. The tendency for a fall in the price level to decrease the real exchange rate and increase net exports is known as the exchange rate effect. 3 . Determinants of aggregate demand

The following graph shows an increase in aggregate demand (AD) in a hypothetical country. Specifically, aggregate demand shifts to the right from

AD1AD1 to AD2AD2, causing the quantity of

output demanded to rise at all price levels. For example, at a price level of 140, output is now $400 billion, where previously it was $300 billion. 010020030040050060070080017016015014013012011010090PRICE LEVELOUTPUT (Billions of dollars)AD1 AD2 The following table lists several determinants of aggregate demand. Complete the table by indicating the change in each determinant necessary to increase aggregate demand.

Change Needed to Increase AD Wealth

Increase

Taxes

Decrease

Expected rate of return on investment

Increase

Incomes in other countries

Increase

Points: 1/1 Close Explanation Explanation:

The level of consumer spending depends, in part, on household wealth. As household wealth rises, consumer spending rises at each price level. An increase in consumer spending leads to an increase in aggregate demand. A decrease in taxes increases households' disposable income. Households will spend more, causing aggregate demand to increase at each price level. The rate of return that businesses expect on capital projects is a key determinant of investment. Suppose a technological breakthrough causes an increase in the expected return on investment. Investment spending will rise, and aggregate demand will increase at each price level. When the incomes of foreigners increase, foreigners will purchase more domestic products, causing exports to rise. Because net exports are one component of aggregate demand, this increase in net exports (exports minus imports) leads to an increase in aggregate demand at each price level. 4 . The slope and position of the long-run aggregate supply curve

Suppose the Fed doubles the growth rate of the quantity of money in the economy. In the long run, the increase in money growth will change which of the following? Check all that apply. The inflation rate The quantity of physical capital The level of technological knowledge The price level Points: 1/1 Close Explanation Explanation: In the long run, the economy's real GDP depends on labor, capital, natural resources, and technological knowledge. Since changes in the quantity of money do not influence these factors, they do not influence the long-run level of output. If the Fed increases money growth, the price level will rise more quickly, and the inflation rate will increase, but the economy's long-run potential output will not change. In the long run, two related propositions hold: Real and nominal variables are separate

(the classical dichotomy), and changes in the quantity of money impact only nominal prices, not production (monetary neutrality). Suppose the economy produces real GDP of $70 billion when unemployment is at its natural rate. Use the purple points (diamond symbol) to plot the economy's long-run aggregate supply (LRAS) curve on the graph. Your AnswerLRAS01020304050607080132128124120116112108104100PRICE LEVELOUTPUT (Billions of dollars)70, 108 Correct Answer Points: 0/1 Close Explanation Explanation: The long-run aggregate supply curve is a vertical line at the economy's natural rate of output. The natural rate of output is the level of output consistent with the economy's natural unemployment rate. It is the level of real GDP that the economy gravitates toward in the long run. The long-run aggregate supply curve is vertical at the natural rate of output because the price level has no bearing on the economy's long-run level of real output. Suppose the government passes a law that significantly increases the minimum wage. The policy will cause the natural rate of unemployment to rise , which will:

Not affect the long-run aggregate supply curve Shift the long-run aggregate supply curve to the left Shift the long-run aggregate supply curve to the right Points: 1/ 1 Close Explanation Explanation:

The position of the long-run aggregate supply curve depends, in part, on the natural rate of unemployment. A policy that increases the natural rate of unemployment will cause the long-run aggregate supply curve to shift to the left. For example, a sharp increase in the minimum wage will increase structural unemployment, thereby raising the natural rate of unemployment and reducing the economy's productive potential. In the following table, determine how each event affects the position of the long-run aggregate supply (LRAS) curve.

Direction of LRAS Curve Shif The government allows more immigration of working-age adults who

Right

find work. This economy's primary source of foreign oil decides to cease exports for

Lef

political reasons. A government-sponsored training program increases the skill level of the

Right

workforce. Points: 1/ 1 Close Explanation Explanation: Loosening immigration restrictions will increase the size of the labor force and the economy's productive ability. An increase in labor shifts the long-run aggregate supply curve to the right. If an economy depends on imports from foreign countries for its oil, a politically motivated oil embargo acts like a reduction in natural resources. The reduced availability of natural resources shifts the longrun aggregate supply curve to the left. An effective training program will increase the skill level of the workforce, boosting the economywide stock of human capital. A more knowledgeable workforce will produce more goods and services. The increase in human capital shifts the long-run aggregate supply curve to the right. 5 . Why the aggregate supply curve slopes upward in the short run

In the short run, the quantity of output that firms supply can deviate from the natural level of output if the actual price level in the economy deviates from the expected price level. Several theories explain how this might happen. For example, the sticky-price theory asserts that the output prices of some goods and services adjust slowly to changes in the price level. Suppose firms announce the prices for their products in advance, based on an expected price level of 100 for the coming year. Many of the firms sell their goods through catalogs and face high costs of reprinting if they change prices. The actual price level turns out to be 110. Faced with high menu costs, the firms that rely on catalog sales choose not to rise , and firms that rely on catalogs will respond by adjust their prices. Sales from catalogs will

increasing

the quantity of output they supply. If enough firms face high costs of adjusting

prices, the unexpected increase in the price level causes the quantity of output supplied to

above

rise

the natural level of output in the short run.

Points: 1/1 Close Explanation Explanation: According to the sticky-price theory, the short-run aggregate supply curve slopes upward because the prices of some products adjust slowly to economic conditions. Some firms set prices for prolonged periods of time because they face high menu costs when prices are adjusted frequently. If the price level turns out to be lower than people expected, the prices of products of firms with more flexible pricing options will be low compared to the prices of products of firms that face high menu costs. Firms with rigid prices will see their sales decline and will cut back on production. An unexpectedly high price level has the opposite effect. Flexible firms will adjust their prices upward, while prices at sticky-price firms will lag behind. Sticky-price firms will see their sales increase because of their relatively low prices, causing them to increase production. Suppose the economy's short-run aggregate supply (AS) curve is given by the following equation:

Quantity of Output Suppl iedQuantity of Output Supplied

= =

Natural Level of Output+α×(Price LevelActual−Price LevelE xpected)Natural Level of Output+α×Price LevelActual−Price LevelExpected

The Greek letter

αα represents a number that determines how much output responds to unexpected

changes in the price level. In this case, assume that

α=$2 billionα=$2 billion. That is, when the

actual price level exceeds the expected price level by 1, the quantity of output supplied will exceed the natural level of output by $2 billion. Suppose the natural level of output is $60 billion of real GDP and that people expect a price level of 110. On the following graph, use the purple line (diamond symbol) to plot this economy's long-run aggregate supply (LRAS) curve. Then use the orange line segments (square symbol) to plot the economy's short-run aggregate supply (AS) curve at each of the following price levels: 100, 105, 110, 115, and 120. Your AnswerASLRAS01020304050607080901001251201151101051009590858075PRICE LEVELOUTPUT (Billions of dollars)80, 120Y-Intercept: 100Slope: 0 Correct Answer Points: 1/1 The short-run quantity of output supplied by firms will fall below the natural level of output when the actual price level falls below the price level that people expected.

Points: 1/1 Close Explanation Explanation: The long-run aggregate supply (LRAS) curve reflects the fact that the money supply and the price level—nominal variables—have no impact on the quantity of goods and services—a real variable—that the economy produces in the long run. The long-run aggregate supply curve is therefore a vertical line at the economy's natural level of output ($60 billion). In the long run, the economy's natural level of output is determined by the size of its labor force, its stocks of human and physical capital, its natural resources, and its technological knowledge. In the short run, the quantity of output supplied by firms fluctuates around the natural level of output when the actual price level turns out to be different from what people expected. For example, an

unexpectedly low price level of 100 causes firms to supply a quantity of output less than the natural level of output in the short run. The short-run aggregate supply curve is therefore upward sloping:

Quantity of Output Suppl iedQuantity of Output Supplied

=

Natural Level of Output+α×(Price LevelActual−Price LevelE xpected)Natural Level of Output+α×Price LevelActual−Price LevelExpected

=

= $60 billion+$2 billion×(100−110)$60 billion+$2 billion×100−110 =

= $60 billion+(−$20) billion$60 billion+−$20 billion =

= $40 billion$40 billion = If the actual price level turns out to be equal to what people expected, output will be equal to the natural level of output:

Quantity of Output SuppliedQuantity of Ou = $60 billion+$2 billion×(110−110)$60 billion+$2 tput Supplied = billion×110−110

=

$60 billion$60 billion

= An unexpectedly high price level of 120 causes firms to supply a quantity of output that exceeds the natural level of output in the short run:

Quantity of Output SuppliedQuantity of Ou = $60 billion+$2 billion×(120−110)$60 billion+$2 tput Supplied = billion×120−110

=

$60 billion+$20 billion$60 billion+$20 billion

=

= =

$80 billion$80 billion

Using the same formula for the remaining price levels produces a short-run aggregate supply curve that goes through the coordinates (40, 100); (50, 105); (60, 110); (70, 115); and (80, 120). 6 . Determinants of aggregate supply

The following graph shows a decrease in short-run aggregate supply (AS) in a hypothetical economy where the currency is the dollar. Specifically, the short-run aggregate supply curve shifts to the left from

AS1AS1 to AS2AS2, causing the quantity of output supplied at a price level of 100 to fall from

$200 billion to $150 billion. 0501001502002503003504002001751501251007550250PRICE LEVELQUANTITY OF OUTPUTAS1 AS2 The following table lists several determinants of short-run aggregate supply. Fill in the table by indicating the changes in the determinants necessary to decrease short-run aggregate supply.

Change Needed to Decrease AS Inflation expectations

Higher

Human capital

Declines

Burdensome regulations

Increase

Points: 1/1 Close Explanation Explanation: If workers, landlords, and firms expect higher rates of inflation in the future, they will negotiate existing wage and rent contracts in order to compensate for rising prices. The increase in wages and rents represents an increase in input costs for firms, reducing the quantity of aggregate output supplied at each price level. Higher inflation expectations shift the AS curve to the left.

Human capital, the knowledge and skills embodied in the workforce, is an important determinant of productivity. Reductions in human capital reduce productivity (output per hour of labor), causing firms to supply a lower quantity of aggregate output at each price level. Declining human capital shifts the AS curve to the left. Burdensome regulations increase the cost of producing output. Adding burdensome regulations will therefore increase firm input costs as firms take on additional costs to comply with the regulations. The higher input costs reduce short-run aggregate supply and shift the AS curve to the left. 7 . Economic fluctuations I

The following graph shows the economy in long-run equilibrium at the expected price level of 120 and the natural level of output o...