CHAPTER 33

AGGREGATE DEMAND AND AGGREGATE SUPPLY

P754 – 755

1. Suppose the economy is in a long-run equilibrium

a.

b. A stock market crush causes aggregate demand to fall, then ADC shifts to the left.
Therefore, output (Y) decreases and price (P) decreases.

When the price level goes down, the aggregate supply decreases in return. The firms decide to
produce less goods and services. They might hire less workers, which increases
unemployment rate. Additionally, employees in finance section might be laid off when the
stock market breaks. In both cases, unemployment rate rises.

c. Due to sticky-wage theory, the wage of workers does not increase in respond to lower
price. The firms will have to reduce production and cut off workers. Over time as
expectations adjust, the short-run aggregate supply curve will shift to the right moving the
economy back to the natural rate of output.
2. Factors that shift the long-run aggregate supply curve: labor, capital, natural resources,
technology
a. Immigration increases the labor force, therefore increases the LRAS
 b. An increase in minimum wage cause unemployment rate to rises. Less labor causes LRAS
to fall.
c. More powerful computer chips mean more advanced technology applied, which increases
LRAS.
d. A severe hurricane does not affect four factors of productions in long term, then it has no
effect on LRAS
3. Suppose an economy is in long-run equilibrium
a.

b. When money supply increases, the interest rate decreases (should be more detailed),
people have incentive to borrow more to invest. An increase in investment will shift ADC to
the right, which causes both price level and output to surge.

c. At B, the actual price was higher than expected. When the economy reaches this long-run
equilibrium, the expected price level will have adjusted to the actual price level. Nominal
wage tends to increase. As a result, the SAS curve will have shifted to the left till it crossed
new equilibrium of the intersection of AD2 and LAS

d. Price level increases from A to B, to C.

According to the sticky-wage theory, the nominal wage does not adjust to changes in price
instantaneously due to long-term contracts. Therefore, nominal wages at point A is equal
to nominal wages at point B.
In the long-run, the labor contracts will expire then nominal wages will increase in respond to higher
price at C.
e. According to the sticky-wage theory, the nominal wage does not adjust to changes in price
simultaneously due to long-term contracts. Therefore, nominal wages at point A is equal to
2
 nominal wages at point B. However, the price at B is higher at A, which means a person
with the same wage can buy less or his real wage is lower.
In the long-run, the wage adjusts to the higher price to remain purchasing power of the wage,
which means real wage at C is equal to real wage at A.
f. Previous analysis showed that money supply does affect the output in short-run but not the
output in long-run. Hence, it is consistent with the precedent claim that money has real
effects in the short-run but is neutral in the long-run.
4. At the recession, the current equilibrium point was lower than the natural rate as showed in the
following model.
The president tried to prolong the shopping periods, which would raise consumption and in turn, shift
the AD to the right. The price level and output would correspondently increase. The not yet
fully recovered economy would be boosted to natural rate.

5. Explain why the following statements are false:

a. The aggregate demand curve depicts the quantity of goods demanded in the whole
economy, where the microeconomic substitution from one market to another is impossible.
Therefore, the micro downward slope demand curve explanation cannot be applied in this
situation.
b. The long-run aggregate-supply curve is vertical because price level does not affect long-run
determinants of output (labor, capital, natural resources, technology)
c. If firms adjust their prices every day, then the short-run aggregate-supply curve would
deviate less from vertical long-run ASC.
Meanwhile, a horizontal SAS means the output increase continuously at a fixed price.
d. An economy recession is possibly because SAS or AD has shifted to left.
6. For each of the three theories for the upwards slope of the short-run AS curve, explain the
following:
a. How the economy recovers from a recession and returns to its long-run equilibrium without
any policy intervention?
● According to the sticky-wage theory, when the economy is in a recession, the output
demand is lower than natural rate and unemployment is higher than natural rate. Over
time, as to avoid unemployment, nominal wages tend to decline, business is less costly
then production will increase, SAS will shift to the right. The economy returns to
natural rate of output and full employment.
● According to the sticky-price theory, the economy is in a recession because not all
prices adjust quickly. Over time, firms are able to adjust their prices more fully, and the
economy returns to the long-run aggregate supply curve.

3
 ● According to the misperceptions theory, the economy is in a recession when the price
level is below what was expected. Over time, as people observe the lower price level,
their expectations adjust, and the economy returns to the long-run aggregate supply
curve.
b. What determines the speed of that recovery?
How quick nominal wages adjust, price level adjusts and expectations adjust. The more flexible the
economy is, the quicker it recovers.
7. Money supply increase leads to lower interest rate, more borrowings and investments and
shifts the AD to the right. At the same, because the public expected this action, the prices
expected also rise and the AS shifts to the left. Based on ADAS model, the output will change
insignificant while price level rises at C.

If the public doesn’t change its expectation in the price level, AD still shifts to the right and SAS stays.
Both the output and the price will increase to B.
8. The economy begins in long-run equilibrium
a. With appearance of a new president of FED with little concern about inflation, loosened
control of inflation is expected. In other words, higher price level is conceived to prevail.
b. The nominal wages will be higher in respond to higher level price in new labor contract.
c. A rise in nominal wages will increase the cost and make the business less profitable at any
given price level.
d. SAS will in turn shift to left as firms decide to produce less.
e. Meanwhile, AD is held constant. ASAD applied, the output will decrease and the price level
will increase from A to B.

4
 f.The appointment might not be a good one due to its predicted short-run negative effects
by ADAS model.
9. Explain shifts in AS or AD and their effects through ADAS model
a. Households decide to save a larger share of their income then the quantity of goods and
services demanded at any prices is lower. The AD shifts to the left. Both the output and
price level decrease.

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

This event makes productions costlier and less profitable. The firms might cut off the production
and AS shifts to the left. Output decreases and price level increases.
c. Increased job opportunities overseas cause many people to leave the country.
This event possibly drives down quantity demanded at any price level and shifts the AD to the left.
Both the output and price level decreases.

10. Explaining effects on long-run, short-run output, price level.

a. The stock market declines sharply, reducing consumer’s wealth. This causes both
consumption and investment to decrease and shifts the AD to the left. In the short-run,
both the output and price decrease at B. In the long-run, as expected price level adjusts, the
AS shifts to the right. The price level continues to decrease but the output goes back to
natural rate at new equilibrium point C.

5
 b. The federal government increases spending on national defense.
This event shifts the AD to the right. In the short-run, both output and price level increase. In the
long-run, as expected prices increases, the SAS shifts to the left, the price level continues to
increases but the output goes back to natural rate.
c. A technological improvement raises productivity.
This events shifts both LAS and SAS to right while AD stays. In short-run, output increases and
price level decreases. In the long-run, output increases and price level decreases as well.

d. A recession overseas causes foreigners to buy fewer U.S goods

This event shifts the AD to the left. In the short-run, both the output and price decrease. In the
long-run, as expected price level adjusts, the AS shifts to the right. The recession
deteriorates and AD shifts back to right. The output goes back to natural rate.
11. Suppose firms become very optimistic about future business.
a. Heavy investment in new capital equipment shifts AD to the right. Both the real output and
price level increase from A to B or equilibrium moves along SASC. In short-run, due to
● sticky-wage theory: more profitable to produce
● sticky-price theory: some firms can sell more because their price was lower than
current level, they will produce more
● misperception theory: some producers misunderstand that their products’ relative
prices have increase then they produce more

All these factors make aggregate quantity of output supplied rise from its natural rate from Y to Y1.

6
 b. In the long-run, higher price level from A to B drives down the aggregate quantity
demanded through wealth effect, interest effect, exchange rate effect. (equilibrium moves
along ADC)
c. An investment boom might lead to capital improvement and increase productivity, thereby
increase aggregate quantity supplied in the long-run. The LAS will shift to the right.
12. In economy A, nominal wages of all workers are completely sticky while in economy B,
nominal wages are half sticky.
Thereby, nominal wages in economy B is less stick and the its SAD is steeper. A 5% increase in
money supply will increase the aggregate quantity demand, which rises the price level and
output. Because price level in economy A is sticker, it rises lesser than in economy B. At
lower new price, the quantity demanded in economy A is higher than in economy B. In
short, money supply has larger impact on output in economy A, larger impact on price level
in economy B.