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

a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate
demand, short-run aggregate supply, and long-run aggregate supply.
b. Now suppose that a stock-market crash causes aggregate demand to fall. Use your
diagram to show what happens to output and the price level in the short run. What
happens to the unemployment rate?
c. Use the sticky-wage theory of aggregate supply to explain what will happen to
output and the price level in the long run (assuming there is no change in policy).
What role does the expected price level play in this adjustment? Be sure to
illustrate your analysis in a graph.
2. Explain whether each of the following events will increase, decrease, or have no effect on the
long-run aggregate supply.
a. The United States experiences a wave of immigration.
b. Congress raises the minimum wage to $10 per hour.
c. Intel invents a new and more powerful computer chip.
d. A severe hurricane damages factories along the East Coast.
3. Suppose an economy is in long-run equilibrium.
a. Use the model of aggregate demand and supply to illustrate the initial equilibrium
(call it point A). Be sure to include both short-run and long-run aggregate supply.
b. The central bank raises the money supply by 5%. Use your diagram to show what
happens to output and the price level as the economy moves from the initial to the
new short-run equilibrium (call it point B).
c. Now show the new long-run equilibrium (call it point C). What causes the economy
to move from point B to point C?
d. According to the stick-wage theory of aggregate supply, how do nominal wages at
point A compare to nominal wages at point B? How do nominal wages at point A
compare to nominal wages at point C?
e. According to the sticky-wage theory of aggregate supply, how do real wages at
point A compare to real wages at point B? How do real wages at point A compare to
real wages at point C?
f. Judging by the impact of the money supply on nominal and real wages, is this
analysis consistent with the proposition that money has real effects in the short run
but is neutral in the long run?

. List and explain the three reasons the aggregate-demand curve is downward sloping.

The aggregate-demand curve is downward sloping because: (1) a decrease in the price level
makes consumers feel wealthier, which in turn encourages them to spend more, so there
is a larger quantity of goods and services demanded; (2) a lower price level reduces the
interest rate, encouraging greater spending on investment, so there is a larger quantity
of goods and services demanded; (3) a fall in the U.S. price level causes U.S. interest
rates to fall, so the real exchange rate depreciates, stimulating U.S. net exports, so there
is a larger quantity of goods and services demanded.
 

2. Explain why the long-run aggregate-supply curve is vertical

 The long-run aggregate supply curve is vertical because in the long run, an economy's supply
of goods and services depends on its supplies of capital, labor, and natural resources and
on the available production technology used to turn these resources into goods and
services. The price level does not affect these long-run determinants of real GDP.
3. What might shift the aggregate-demand curve to the left? Use the model of aggregate demand
and aggregate supply to trace through the short-run and long-run effects of such a shift on output
and the price level

The aggregate-demand curve might shift to the left when something (other than a rise in the
price level) causes a reduction in consumption spending (such as a desire for increased
saving), a reduction in investment spending (such as increased taxes on the returns to
investment), decreased government spending (such as a cutback in defense spending),
or reduced net exports (such as when foreign economies go into recession).
 

The figure below traces through the steps of such a shift in aggregate demand. The economy
begins in equilibrium, with short-run aggregate supply, AS1, intersecting aggregate
demand, AD1, at point A. When the aggregate-demand curve shifts to the left to AD2, the
economy moves from point A to point B, reducing the price level and the quantity of
output. Over time, people adjust their perceptions, wages, and prices, shifting the short-
run aggregate-supply curve down to AS2, and moving the economy from point B to point
C, which is back on the long-run aggregate-supply curve and has a lower price level.

4. What might shift the aggregate-supply curve to the left? Use the model of aggregate demand and
aggregate supply to trace through the short-run and long-run effects of such a shift on output and
the price level

The aggregate-supply curve might shift to the left because of a decline in the economy's
capital stock, labor supply, or productivity, or an increase in the natural rate of
unemployment, all of which shift both the long-run and short-run aggregate-supply
curves to the left. An increase in the expected price level shifts just the short-run
aggregate-supply curve (not the long-run aggregate-supply curve) to the left.
 
The figure below traces through the effects of a shift in short-run aggregate supply. The
economy starts in equilibrium at point A. The aggregate-supply curve shifts to the left
from AS1 to AS2. The new equilibrium is at point B, the intersection of the aggregate-
demand curve and AS2. As time goes on, perceptions and expectations adjust and the
economy returns to long-run equilibrium at point A, because the short-run aggregate-
supply curve shifts back to its original position.
 5.       Suppose the economy is in a long-run equilibrium

a.       Draw a diagram to illustrate the state of the economy. Be sure to show aggregate
demand, short-run aggregate supply, and long-run aggregate supply.
b.      Now suppose that a stock-market crash causes aggregate demand to fall. Use your
diagram to show what happens to output and price level in the short run. What
happens to the unemployment rate?
A stock market crash leads to a leftward shift of aggregate demand. The equilibrium level
of output and the price level will fall. Because the quantity of output is less than the
natural rate of output, the unemployment rate will rise above the natural rate of
unemployment.
 

c.       Use the sticky-wage theory of aggregate supply to explain what will happen to
output and the price level in the long run (assuming there is no change in policy).
What role does the expected price level play in this adjustment? Be sure to illustrate
your analysis in a graph.
If nominal wages are unchanged as the price level falls, firms will be forced to cut back
on employment and production. 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.
 
6.       Explain whether each of the following events will increase, decrease, or have no effect on
short-run aggregate supply.  Illustrate your answer with a AD/AS graph and show the SR
equilibrium.
a.       The United States experiences a wave of immigration
When the United States experiences a wave of immigration, the labor force increases, so
long-run aggregate supply shifts to the right.
 

b.      Congress raises the minimum wage to $10 per hour

When Congress raises the minimum wage to $10 per hour, the natural rate of
unemployment rises, so the long-run aggregate-supply curve shifts to the left.
c.       Intel invents a new and more powerful computer chip
When Intel invents a new and more powerful computer chip, productivity increases, so
long-run aggregate supply increases because more output can be produced with the
same inputs.
 
 d.      A severe hurricane damages factories long the East Coast.
When a severe hurricane damages factories along the East Coast, the capital stock is
smaller, so long-run aggregate supply declines.
 
7.       In 1939, the U.S. economy not yet fully recovered from the Great Depression, President
Roosevelt proclaimed that Thanksgiving would fall a week earlier than usual so that the
shopping period before Christmas would be longer. Explain what President Roosevelt might
have been trying to achieve, using the model of aggregate demand and aggregate supply.
The idea of lengthening the shopping period between Thanksgiving and Christmas was to
increase aggregate demand. This could increase output back to its long-run equilibrium level
 
8.       Explain why the following statements are false.
a.       “The aggregate-demand curve slopes down ward because it is the horizontal sum of
the demand curves for individual goods.”
The statement that "the aggregate-demand curve slopes downward because it is the
horizontal sum of the demand curves for individual goods" is false. The aggregate-
demand curve slopes downward because a fall in the price level raises the overall
quantity of goods and services demanded through the wealth effect, the interest-rate
effect, and the exchange-rate effect.
b.      “The long-run aggregate-supply curve is vertical because economic forces do not
affect long-run aggregate supply.”
The statement that "the long-run aggregate-supply curve is vertical because economic
forces do not affect long-run aggregate supply" is false. Economic forces of various
kinds (such as population and productivity) do affect long-run aggregate supply. The
long-run aggregate-supply curve is vertical because the price level does not affect
long-run aggregate supply.
c.       “If firms adjusted their prices every day, then the short-run aggregate-supply curve
would be horizontal.”
The statement that "if firms adjusted their prices every day, then the short-run
aggregate-supply curve would be horizontal" is false. If firms adjusted prices quickly
and if sticky prices were the only possible cause for the upward slope of the short-
run aggregate-supply curve, then the short-run aggregate-supply curve would be
vertical, not horizontal. The short-run aggregate supply curve would be horizontal
only if prices were completely fixed.
d.      “Whenever the economy enters a recession, its long-run aggregate-supply curve
shifts to the left.”
The statement that "whenever the economy enters a recession, its long-run aggregate-
supply curve shifts to the left" is false. An economy could enter a recession if either
the aggregate-demand curve or the short-run aggregate-supply curve shifts to the
left.
9.       Suppose that the economy is currently in a recession. If policymakers that no action, how
will the economy change over time? Explain in words and using an aggregate-
demand/aggregate-supply diagram.
The figure below depicts an economy in a recession. The short-run aggregate-supply curve
is AS1and the economy is at equilibrium at point A, which is to the left of the long-run
aggregate-supply curve. If policymakers take no action, the economy will return to the
long-run aggregate-supply curve over time as the short-run aggregate-supply curve shifts
to the right to AS2. The economy's new equilibrium is at point B.
 
 10.   For each of the following events, explain the short-run and long-run effects on output and
the price level, assuming policymakers take no actions.  Illustrate your answers in both the 3-
graph framework and the AD/AS framework
a.       The stock market declines sharply, reducing consumers’ wealth.
When the stock market declines sharply, wealth declines, so the aggregate-demand curve
shifts to the left, as shown in Figure. In the short run, the economy moves from point
A to point B, as output declines and the price level declines. In the long run, the
short-run aggregate-supply curve shifts to the right to restore equilibrium at point C,
with unchanged output and a lower price level compared to point A.
 

b.      The federal government increases spending on national defense.

When the federal government increases spending on national defense, the rise in
government purchases shifts the aggregate-demand curve to the right, as shown in
the figure. In the short run, the economy moves from point A to point B, as output
and the price level rise. In the long run, the short-run aggregate-supply curve shifts
to the left to restore equilibrium at point C, with unchanged output and a higher price
level compared to point A.
 c.       A technological improvement raises productivity
When a technological improvement raises productivity, the long-run and short-run
aggregate-supply curves shift to the right, as shown in the figure. The economy
moves from point A to point B, as output rises and the price level declines.
 
 

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

When a recession overseas causes foreigners to buy fewer U.S. goods, net exports
decline, so the aggregate-demand curve shifts to the left, as shown in the figure. In
the short run, the economy moves from point A to point B, as output declines and
the price level declines. In the long run, the short-run aggregate-supply curve shifts
to the right to restore equilibrium at point C, with unchanged output and a lower
price level compared to point A.
When the economy goes into recession, real GDP _____ and unemployment _____
recession: real GDP falls, unemployment rises
A sudden crash in the stock market shifts the
the aggregate-demand curve
A change in the expected price level shifts
the short-run aggregate-supply curve
An increase in the aggregate demand for goods and services has a larger impact on
output _____ and a larger impact on the price level _____
in the short run, in the long run
stagflation is caused by
a leftward shift in the aggregate-supply curve
the idea that economics downturns results from an inadequate aggregate demand
for goods and services is derived from the work of which economist
John Keynes

a.According to the sticky-wage theory,the economy is in a recession because the price level has
declined so that real wages are too high, thus labor demand is too low. Over time, as nominal
wages are adjusted so that real wages decline, the economy returns to 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.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.The speed of the recovery in each theory depends on how quickly price expectations, wages, and
prices adjust.

a.The statement that "the aggregate-demand curve slopes downward because it is the horizontal
sum of the demand curves for individual goods" is false. The aggregate-demand curve slopes
downward because a fall in the price level raises the overall quantity of goods and services
demanded through the wealth effect, the interest-rate effect, and the exchange-rate effect.b.The
statement that "the long-run aggregate-supply curve is vertical because economic forces do not
affect long-run aggregate supply" is false. Economic forces of various kinds (such as population
and productivity) do affect long-run aggregate supply. The long-run aggregate-supply curve is
vertical because the price level does not affect long-run aggregate supply.c.The statement that "if
firms adjusted their prices every day, then the short-run aggregate-supply curve would be
horizontal" is false. If firms adjusted prices quickly and if sticky prices were the only possible cause
for the upward slope of the short-run aggregate-supply curve, then the short-run aggregate-supply
curve would be vertical, not horizontal. The short-run aggregate supply curve would be horizontal
only if prices were completely fixed.d.The statement that "whenever the economy enters a
recession, its long-run aggregate-supply curve shifts to the left" is false. An economy could enter a
recession if either the aggregate-demand curve or the short-run aggregate-supply curve shifts to
the left.
1.
a. The current state of the economy is shown in Figure 1. The aggregate-demand curve and
short-run aggregate-supply curve intersect at the same point on the long-run aggregate-
supply curve.
b. A stock market crash leads to a leftward shift of aggregate demand. The equilibrium level of
output and the price level will fall. Because the quantity of output is less than the natural
rate of output, the unemployment rate will rise above the natural rate of unemployment.
c. If nominal wages are unchanged as the price level falls, firms will be forced to cut back on
employment and production. 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.

Figure 1.

2.

a. When the United States experiences a wave of immigration, the labor force increases,
so long-run aggregate supply shifts to the right.
b. When Congress raises the minimum wage to $10 per hour, the natural rate of
unemployment rises, so the long-run aggregate-supply curve shifts to the left.
c. When Intel invents a new and more powerful computer chip, productivity increases, so
long-run aggregate supply increases because more output can be produced with the
same inputs.
d. When a severe hurricane damages factories along the East Coast, the capital stock is
smaller, so long-run aggregate supply declines.
3.
a. The current state of the economy is shown in Figure 2. The aggregate-demand curve
and short-run aggregate-supply curve intersect at the same point on the long-run
aggregate-supply curve.
b. If the central bank increases the money supply, aggregate demand shifts to the right (to
point B). In the short run, there is an increase in output and the price level.
c. Over time, nominal wages, prices, and perceptions will adjust to this new price level. As
a result, the short-run aggregate-supply curve will shift to the left. The economy will
return to its natural rate of output (point C).
d. According to the sticky-wage theory, nominal wages at points A and B are equal.
However, nominal wages at point C are higher.
e. According to the sticky-wage theory, real wages at point B are lower than real wages at
point A. However, real wages at points A and C are equal.
f. Yes, this analysis is consistent with long-run monetary neutrality. In the long run, an
increase in the money supply causes an increase in the nominal wage, but leaves the
real wage unchanged.

Figure 2.