1 Aggregate Demand 4. Explain the intuition behind the wea.docx

1 Aggregate Demand
4. Explain the intuition behind the wealth, interest rate, and
exchange rate effects.
The intuition behind the real wealth effect is that when the price
level decreases, it takes less
money to buy goods and services. The money you have is now
worth more and you feel
wealthier. So, in response to a decrease in the price level, real
GDP will increase. More
formally, this means that when households’ assets are worth
more in terms of their
purchasing power, they are more likely to purchase more goods
and services.
The opposite happens when the price level increases. If the
price of everything increases, but
the number of dollars you have doesn’t, then you have to cut
back on spending. Some
shorthand of this chain of events can help us wrap our heads
around this:
PL↓→real wealth ↑→consumption increases→move right along
AD curve

The intuition behind the interest rate effect is that when the
price level decreases, you need
less money in your pocket to buy stuff. The less money you
need to keep on hand to buy
stuff, the more money you are going to keep in a bank. Banks
pay interest to try to lure
people to deposit their money in banks. So, if you are going to
keep more money in the bank
anyway, banks don’t have to offer as much interest in order to
convince you; that drives
interest rates down. As a result, businesses and households
spend more money on investment
and “big ticket” items that are interest sensitive, like X, Y, and
Z. So, once again, a decrease
in the price level will increase real GDP.
On the other hand, a higher price level will drive up interest
rates. Remember how a higher
price level would make everyone’s dollars are worth less, and
they cut back on consumption?
Well, what if they didn’t want to cut back on consumption.
Instead, maybe they sell off some
other asset like a bond to try to get more money. The problem
is, every other bondholder is
also trying to sell off their bonds, so there are no buyers!

Anyone who wants to issue a new
bond is going to have to do something to try to attract buyers.
The way to do that is to raise
the interest rate that is offered. All of that excess demand for
money leads to an increase in
the interest rate.
Finally, the intuition behind the exchange rate effect is that a
decrease in the price level in
country A makes its goods cheaper to country B, so country B
buys more of country A’s
exports. When the price level in one country goes down, its
goods are suddenly more
attractive to every other country. It’s like the whole country is
on sale! Since that country’s
goods are suddenly cheaper, their exports go up.
2 Multipliers
4. Households in Iron Island save 10% of every additional
dollar in income that they
receive. What will happen to aggregate demand Maggietopia if
there is a $4 billion
increase in lump-sum taxes?

Note: Please answer this question on your own.
3 Short-run Aggregate Supply (SRAS)
2. Describe why there is a short-run relationship between the
unemployment rate and
ination. Can you think of a reason why this might not hold up in
the long run?
When there is an increase in the price level (inflation), the
workers that firms can hire at their
old, stuck wages are relatively cheaper than they used to be.
Since labor is now cheaper,
firms are willing to hire more workers, driving down the
unemployment rate. Therefore, there
is a short-run negative relationship between inflation and
unemployment.
However, it would be surprising if workers are permanently
willing to take the same pay if
prices all around them are going up. When there is inflation,
real wages are decreasing. We
should expect the workers to get pretty insistent about
“unsticking” those stuck wages

eventually.
3. What causes SRAS to shift? [Explain]
When the price level changes and firms produce more in
response to that, we move along the
SRAS curve. But, any change that makes production different at
every possible price level
will shift the SRAS curve. Events like these are called “shocks”
because they aren’t
anticipated.
For example, imagine the price of labor unexpectedly gets more
expensive. In response to
that shock, the SRAS curve decreases (shifts to the left).
Interestingly, this happens if firms
expect that this will happen too. If you see it coming, you adjust
your expectations
accordingly! If factors of production get cheaper, or producers
think they will get cheaper,
then SRAS increases.
You can easily remember all of the shocks that shift SRAS by
thinking of SPITE:
Subsidies for businesses
Productivity

Input prices
Taxes on businesses
Expectations about inflation
4. Why is SRAS curve upward sloping? [Explain]
The SRAS curve slopes up for two reasons: sticky input prices
(like wages) and sticky output
prices (also called “menu costs”)
5. Describe sticky wage theory to someone who has never heard
of it before. How would
you describe it?
(also called nominal price rigidity) the idea that some prices
and wages are not fully flexible
and cannot completely respond to changes such as inflation or
deflation
4 Long-run Aggregate Supply (LRAS)
1. What are the reasons that the aggregate supply curve is
vertical in the long-run but
not in the short-run?
The LRAS is vertical because, in the long-run, the potential

output an economy can produce
isn’t related to the price level. There are only two things that
matter for potential output: 1)
the quantity and the quality of a country’s resources, and 2)
how it can combine those
resources to produce aggregate output. When an economy is
producing exactly its full
employment output, the rate of unemployment is equal to the
natural rate of unemployment.
The LRAS curve is also vertical at the full-employment level of
output because this is the
amount that would be produced once prices are fully able to
adjust. In the short-run, some
prices are sticky. This means that producers might respond to
changes in the price level by
changing their output. However, in the long-run, those prices
get “unstuck,” and once they
have fully adjusted the economy will produce the efficient, full
employment output.
2. If an economy is producing its potential output, is the current
rate of unemployment
less than, greater than, or equal to the natural rate of
unemployment? Explain.

If an economy is producing its potential output, the current rate
of unemployment would be
equal to the natural rate of unemployment. Potential output is
how much would be produced
if all resources, including labor, are used efficiently. If labor is
being used efficiently, there is
no excess unemployment or over employment.
5 Equilibrium in the AD-AS model
1. What is the difference between a short-run equilibrium and a
long-run
equilibrium?
The short-run equilibrium is the point where SRAS and AD
intersect, which yields Y_1Y1Y,
start subscript, 1, end subscript as the current output and
PL_1PL1P, L, start subscript, 1, end
subscript as the current price level. Notice that Y_1Y1Y, start
subscript, 1, end subscript is
more than Y_fYfY, start subscript, f, end subscript, which
means that the economy is
producing more than full employment output and has an
inflationary gap (another way of

saying this would be that the economy is experiencing a
positive output gap).
The short-run equilibrium is the point where SRAS and AD
intersect, which yields Y_1Y1Y,
start subscript, 1, end subscript as the current output and
PL_1PL1P, L, start subscript, 1, end
subscript as the current price level. Notice two things about
this. First, Y_1Y1Y, start
subscript, 1, end subscript is equal to Y_fYfY, start subscript, f,
end subscript, which means
that the economy is producing exactly its full employment
output and is in long-run
equilibrium. Second, LRAS is always vertical at this point, so
the long-run equilibrium is
where all three of these curves intersect.
That’s really the way to think about a long-run equilibrium—its
really two equilibrium. The
short-run equilibrium (where AD is equal to SRAS) is what the
country is currently
producing (Y_1Y1Y, start subscript, 1, end subscript). The
definition of the long-run in
economics is long enough for all prices to adjust. When all
prices have adjusted, the short-run

output will also be the full employment output.
Note:
https://www.khanacademy.org/economics-finance-
domain/macroeconomics/aggregate-
supply-demand-topic/macro-equilibrium-in-the-ad-as-
model/a/lesson-summary-equilibrium-
in-the-ad-as-model
The answer is in the link above, please find it and paraphrase it.
It is the same above answer
but I include the link for your reference because here the
mathematical notations are not clear
as on the website.
2. Assume the economy of Johnsrudia is currently operating at
short-run equilibrium
and producing $300 million in real GDP and a CPI of 190.
However, the full
employment rate of output in Johnsrudia is $350 million. Draw
a correctly labeled
graph of the AD-AS model that reflects this information.
If the economy of Maxistan is experiencing the following
condition:UR>UR_NUR>URNU,

R, is greater than, U, R, start subscript, N, end subscript then
Maxistan is experiencing a
negative output gap and is producing less than its full
employment output. This means that
when we are drawing our AD-AS model, we need to make sure
that the LRAS curve is to
the right of the current output, as shown in Figure X.
domain/macroeconomics/aggregate-supply-demand-topic/macro-
equilibrium-in-the-ad-as-model/a/lesson-summary-equilibrium-
in-the-ad-as-model
in-the-ad-as-model
in-the-ad-as-model
When an economy is producing less than full employment
output, it is operating at a
point inside the PPC, as shown in Figure X.
6 Changes in the AD-AS model in the short run
6.1 Shifts in Aggregate Demand

1. How would a dramatic increase in the value of the stock
market shift the AD curve?
What effect would the shift have on the equilibrium level of
GDP and the price level?
An increase in the value of the stock market would make
individuals feel wealthier and thus
more confident about their economic situation. This would
likely cause an increase in
consumer confidence leading to an increase in consumer
spending, shifting the AD curve to
the right. The result would be an increase in the equilibrium
level of GDP and an increase in
the price level.
2. Suppose Mexico, one of our largest trading partners and
purchaser of a large
quantity of our exports, goes into a recession. Use the AD/AS
model to determine the
likely impact on our equilibrium GDP and price level.
Since imports depend on GDP, if Mexico goes into recession, its
GDP declines and so do its
imports. This decline in our exports can be shown as a leftward
shift in AD, leading to a

decrease in our GDP and price level.
3. A policymaker claims that tax cuts led the economy out of a
recession. Can we use
the AD/AS diagram to show this?
Tax cuts increase consumer and investment spending, depending
on where the tax cuts are
targeted. This would shift AD to the right. If the tax cuts
occurred when the economy was in
recession—and GDP was less than potential—the tax cuts would
increase GDP and “lead the
economy out of recession.”
4. Many financial analysts and economists eagerly await reports
on the home price
index and consumer confidence index. What would be the
effects of negative reports on
both of these? What about positive reports?
A negative report on home prices would make consumers feel
like the value of their homes—
which for most Americans is a major portion of their wealth—

has declined. A negative report
on consumer confidence would make consumers feel pessimistic
about the future. Both of
these would likely reduce consumer spending, shifting AD to
the left, reducing GDP and the
price level.
A positive report on the home price index or consumer
confidence would do the opposite.
5. Name some factors that could cause AD to shift, and explain
whether they would shift
AD to the right or to the left.
If we consider that: real GDP = C + I + G + NX (consumption +
investment + government
spending + net exports)
Factors causing AD to shift to the right:
- Tax cuts: making consumers more confident --> C rises and so
does real GDP
- Tax benefits for companies investing --> I rises and so does
real GDP
- Spending on new road infrastructures --> G rises and so does
real GDP
- New trade agreement with a new partner --> NX rise and so

does real GDP
Factors causing AD to shift to the left:
- Austerity policy by the government --> reduces G and real
GDP
- Having a trade partner going into recession --> NX decrease
and so does real GDP
6. Would a shift of AD to the right tend to make the equilibrium
quantity and price
level higher or lower? What about a shift of AD to the left?
If the AD curve shifts to the right, then the equilibrium quantity
of output and the price level
will rise. If the AD curve shifts to the left, then the equilibrium
quantity of output and the
price level will fall.
7. If households decided to save a larger portion of their
income, what effect would this
have on the output, employment, and price level in the short
run? What about the
long run?
*In the Short Run...*
-If households save more, they are spending less. Household

consumption would decrease
which would shift the Aggregate demand curve to the left. This
shift will cause a new ad/as
equilibrium. * If the AD curve shifts to the left, then the
equilibrium quantity of output and
the price level will fall.
Also, with this shift, employment would decrease due to a less
demand for output.
In the long-run, the saving increase will bring an increase in
investment, which is an
important element of productivity. So the AS will shift to the
right in the long-run (with the
potential supply vertical line shifting to the right too) . Finally,
the total output will increase
again while the price level fall even further.
8. If firms became more optimistic about the future of the
economy and, at the same
time, innovation in 3-D printing made most workers more
productive, what would the
combined effect on output, employment, and the price-level be?
https://www.chegg.com/homework-help/firms-become-
optimistic-future-economy-time-

innovation-3-d-p-chapter-10-problem-49ctq-solution-
9781938168963-exc
optimistic-future-economy-time-innovation-3-d-p-chapter-10-
problem-49ctq-solution-9781938168963-exc
optimistic-future-economy-time-innovation-3-d-p-chapter-10-
problem-49ctq-solution-9781938168963-exc
Note: The answer is in the above link, please find it and
paraphrase it.
9. If the US Congress cut taxes at the same time that businesses
became more
pessimistic about the economy, what would the combined effect
on output, the price
level, and employment be, based on the AD/AS diagram?
- Tax cuts will increase consumption spending and business
investment spending. If
businesses are pessimistic and not increasing investment
spending with this new incentive,
then the increase in consumption spending will decrease any
effects a decrease in business
investment spending would have had. Effectively, the tax cut

would keep the aggregate
demand curve in it's current position and ad/as equilibrium
would not change.
Therefore, Price level, output and employment would all remain
the same.
6.2 Shifts in Short-run Aggregate Supply
1. Suppose the US Congress passes significant immigration
reform that makes it easier
for foreigners to come to the United States to work. Use the
AD/AS model to explain
how this would affect the equilibrium level of GDP and the
price level.
Immigration reform, as described, should increase the labor
supply, shifting SRAS to the
right, leading to a higher equilibrium GDP and a lower price
level.
2. Suppose concerns about the size of the federal budget deficit
lead the US Congress to
cut all funding for research and development for 10 years.
Assuming this has an impact
on technology growth, what does the AD/AS model predict
would be the likely effect

on equilibrium GDP and the price level?
Given the assumptions made in the question, the cuts in
research and development funding
should reduce productivity growth. The model would show this
as a leftward shift in the
SRAS curve, leading to a lower equilibrium GDP and a higher
price level.
3. Name some factors that could cause the SRAS curve to shift,
and explain whether
they would shift SRAS to the right or to the left.
SRAS will shift to the left because productivity decreases. That
leads to a lower output level
(GDP), and a higher price level.
4. Will the shift of SRAS to the right tend to make the
equilibrium quantity and price
level higher or lower? What about a shift of SRAS to the left?
If the aggregate supply—also referred to as the short-run
aggregate supply or SRAS—curve
shifts to the right, then a greater quantity of real GDP is
produced at every price level. If the
aggregate supply curve shifts to the left, then a lower quantity

of real GDP is produced at
every price level.
5. What is stagflation?
When an economy experiences stagnant growth and high
inflation at the same time
6.3 Summary
2. In a previous lesson it was stated that there is a negative
relationship between
unemployment and inflation in the short run. A shock to one of
our curves is consistent
with this idea, but a shock to the other curve is not actually
consistent with a negative
relationship between unemployment and inflation. What kind of
shift is consistent
with this relationship, and which is not?
Shifts in AD are consistent with an inverse relationship between
inflation and unemployment,
but this relationship does not hold up when SRAS shifts. We
can summarize what happens to
inflation and unemployment when AD and SRAS shift as shown
in the table below:

Change
Effect on
Employment
Effect on
Inflation
Consistent with an
inverse relationship?
AD uparrow↑ UR downarrow↓ Inf uparrow↑ YES
AD downarrow↓ UR uparrow↑ Inf downarrow↓ YES
SRAS uparrow↑ UR downarrow↓ Inf downarrow↓ NO
SRAS downarrow↓ UR uparrow↑ Inf uparrow↑ NO
Remember, the inverse relationship between inflation and
unemployment exists in the short
run, but not in the long run. We will see this developed within
the AD-AS model in our next
lesson.
3. During the 1970s, the United States was hit with an oil
embargo which dramatically
increased the price of energy. Explain how this would impact

output, ination, and
the unemployment rate.
The oil embargo would be an example of a negative supply
shock. This decreases real GDP
(which means that output decreased), increases unemployment,
and increases the aggregate
price level (resulting in inflation). Graphically, the short run
supply curve will shift to the
left, meaning that less output will be produced at every price
level.
7 Long-run self adjustment in the AD-AS model
1. The economy of Johnsrudia is experiencing a positive output
gap caused by an
increase in consumption. Describe the chain of events that
would lead the economy to
return to producing its full employment output.
When consumption increases, this will cause AD to increase.
The price level will increase as
a result. Higher inflation will lead businesses and workers to
believe that prices will be higher
in the future as well, and so wages increase. The change in
expectations and input prices will

lead SRAS to decrease. This will return output to the full
employment level, and the
unemployment rate will return to the natural rate of
unemployment.
We can use short-hand to describe this chain of events too:
Consumption uparrow↑
rightarrow→right arrow AD uparrow↑
rightarrow→right arrow inflation uparrow↑, output uparrow↑,
unemployment downarrow↓
rightarrow→right arrow increase in inflation expectations
rightarrow→right arrow SRAS downarrow↓ rightarrow→right
arrow Y=Yf, UR=URn.
2. What might prevent the self-correction mechanism from
occurring?
3. During the 2008 recession in the United States, a decrease in
consumption and
investment spending lead to a decrease in aggregate demand.
Describe the chain of
events that would lead the economy to return to a long-run
equilibrium.
Note: Please answer questions #2 and #3. you may find the
answers in the below link.

https://www.khanacademy.org/economics-finance-domain/ap-
macroeconomics/national-
income-and-price-determinations/long-run-self-adjustment-
ap/a/lesson-summary-long-run-
self-adjustment-in-the-ad-as-model
macroeconomics/national-income-and-price-
determinations/long-run-self-adjustment-ap/a/lesson-summary-
long-run-self-adjustment-in-the-ad-as-model

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