A.The Current State of the Economy Is Shown in Figure 6. the Aggregate-Demand Curve (AD1)

Question 1

Figure 6

a.The current state of the economy is shown in Figure 6. The aggregate-demand curve (AD1) and short-run aggregate-supply curve (SRAS1) 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 (to AD2). 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 (to SRAS2), moving the economy back to the natural rate of output.

Question 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.

Question 3

During the Great Depression, equilibrium output (Y1) was lower than the natural rate of output (Y2). The idea of lengthening the shopping period between Thanksgiving and Christmas was to increase aggregate demand. As Figure 8 shows, this could increase output back to its long-run equilibrium level (Y2).

Figure 8

Question 4

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.

Question 5

a.The theory of liquidity preference is Keynes's theory of how the interest rate is determined. According to the theory, the aggregate-demand curve slopes downward because: (1) a higher price level raises money demand; (2) higher money demand leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services demanded. Thus, the price level has a negative relationship with the quantity of goods and services demanded.

b.A decrease in the money supply shifts the money-supply curve to the left. The equilibrium interest rate will rise. The higher interest rate reduces consumption and investment, so aggregate demand falls. Thus, the aggregate-demand curve shifts to the left.

c.If the government spends $3 billion to buy police cars, aggregate demand might increase by more than $3 billion because of the multiplier effect on aggregate demand. Aggregate demand might increase by less than $3 billion because of the crowding-out effect on aggregate demand.

Question 6

a.If pessimism sweeps the country, households reduce consumption spending and firms reduce investment, so aggregate demand falls. If the Fed wants to stabilize aggregate demand, it must increase the money supply, reducing the interest rate, which will induce households to save less and spend more and will encourage firms to invest more, both of which will increase aggregate demand. If the Fed does not increase the money supply, Congress could increase government purchases or reduce taxes to increase aggregate demand.

b.Government policies that act as automatic stabilizers include the tax system and government spending through the unemployment-benefit system. The tax system acts as an automatic stabilizer because when incomes are high, people pay more in taxes, so they cannot spend as much. When incomes are low, so are taxes; thus, people can spend more. The result is that spending is partly stabilized. Government spending through the unemployment-benefit system acts as an automatic stabilizer because in recessions the government transfers money to the unemployed so their incomes do not fall as much and thus their spending will not fall as much.

Question 7

Figure 6

a.When fewer ATMs are available, money demand is increased and the money-demand curve shifts to the right from MD1 to MD2, as shown in Figure 6. If the Fed does not change the money supply, which is at MS1, the interest rate will rise from r1 to r2. The increase in the interest rate shifts the aggregate-demand curve to the left, as consumption and investment fall.

b.If the Fed wants to stabilize aggregate demand, it should increase the money supply to MS2, so the interest rate will remain at r1 and aggregate demand will not change.

c.To increase the money supply using open market operations, the Fed should buy government bonds.

Question 8

A tax cut that is permanent will have a bigger impact on consumer spending and aggregate demand. If the tax cut is permanent, consumers will view it as adding substantially to their financial resources, and they will increase their spending substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they will not increase spending as much.