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Chapter 20 Aggregate Demand

and Supply• Key Concepts• Summary• Practice Quiz• Internet Exercises

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In this chapter, you will learn to solve these economic puzzles:

Why does the aggregate supply curve have three

different segments?

Would the greenhouse effect cause inflation,

unemployment, or both?

Was John Maynard Keynes’s prescription

for the Great Depression right?

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What is the Aggregate Demand Curve?

The curve shows the level of real GDP purchased by households, businesses, government, and foreigners at different price levels during a time period, ceteris paribus

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What does the Horizontal Axis measure?

The value of final goods and services included in real GDP measured in base year dollars

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What does the Vertical Axis measure?

It is an index of the overall price level, such as the GDP deflator or the CPI

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Why does the Aggregate Demand Curve slope

downward to the right?• Real balance wealth effect• Interest rate effect• Net exports effect

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What is theReal Balance Effect?

Consumers spend more on goods and services because lower prices make their dollars more valuable

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What is theInterest Rate Effect?

Assuming fixed credit, an increase in the price level translates through higher interest rates into a lower real GDP

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What is theNet Exports Effect?

A higher domestic price level makes U.S. goods more expensive compared to foreign goods, exports decrease, imports increase, decreasing real GDP

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The Aggregate Demand Curve

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What can cause a shift in the Aggregate Demand Curve?

Consumption, investments, government spending and net exports can change

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A Shift in the Aggregate Demand Curve

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What is theAggregate Supply Curve?

The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus

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Why did Keynes assume fixed product

prices and wages?During a deep recession or

depression, there are many idle resources in the economy

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Why do idle Resources mean Fixed Prices?

Producers are willing to sell additional output at current prices because there is plenty of resources to go around for everyone who wants them

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Why do idle Resources mean Fixed Wages?

The supply of unemployed workers willing to work for the prevailing wage rate diminishes the power of workers to increase their wages

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What kind of Supply Curve would explain

Fixed Prices and Wages?A horizontal supply curve

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The Keynesian Horizontal Aggregate Supply Curve

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Government spending (G)

increases

Aggregate demand increases and the economy moves

from E1 to E2

Price level remains constant, while real

GDP and employment rise

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According to Keynes, what will a shift in

Aggregate Demand do?It will restore a

depressed economy to full employment

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The Keynesian Horizontal Aggregate Supply Curve

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What is the Classical view of the Aggregate

Supply Curve?It is a vertical line at the

full employment output

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According to the Classical Economists,

where does the economy normally operate? The economy normally

operates at its full employment level

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How do the Classical Economists view Prices and Costs?

The price level of products and production costs change by the same percentage in order to maintain full employment

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The Classical Aggregate Supply Curve

ASSurplusP

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PI)

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Three Ranges of the Aggregate Supply CurveAS

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Increasing Demand

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What factors can cause a shift in the

Aggregate Supply Curve?A change in ~• resource prices• technology• taxes• subsidies• regulations

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A Rightward Shift in the Aggregate Supply CurveAS1

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Change in one or more nonprice-level determinants: resource prices, technological change,

taxes, subsidies, and regulations

Increase in the aggregate supply curve

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What are the two types of Inflation?

• Cost push• Demand pull

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What isCost Push Inflation?A rise in the general

price level resulting from an increase in the cost of production

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Cost Push Inflation

AS2P

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What isDemand Pull Inflation?A rise in the general price

level resulting from an excess of total spending

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Demand Pull Inflation

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What determines the Business Cycle?

Shifts in the aggregate demand and aggregate supply curves

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Key Concepts

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Key Concepts• What is the Aggregate Demand Curve?

• Why does the Aggregate Demand Curve slope downward to the right?

• What can cause a shift in the Aggregate Demand Curve?

• What is the Aggregate Supply Curve?

• Why did Keynes assume fixed product prices and wages?

• What kind of Supply Curve would explain Fixed Prices and Wages?

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Key Concepts cont.• According to Keynes, what will a shift in Agg

regate Demand do?

• What is the Classical view of the Aggregate Supply Curve?

• According to the Classical Economists, where does the economy normally operate?

• What factors can cause a shift in the Aggregate Supply Curve?

• What are the two types of Inflation?

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Summary

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The aggregate demand curve shows the level of real GDP purchased in the economy at different price levels during a period of time.

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Reasons why the aggregate demand curve is downward-sloping include the following three effects:

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(1) The real balances or wealth effect is the impact on real GDP caused by the inverse relationship between the purchasing power of fixed value financial assets and inflation, which causes a shift in the consumption schedule.

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(2) The interest-rate effect assumes a fixed money supply, and, therefore, inflation increases the demand for money. As the demand for money increases, the interest rate rises, causing consumption and investment spending to fall.

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(3) The net exports effect is the impact on real GDP caused by the inverse relationship between net exports and inflation. An increase in the U.S. price level tends to reduce U.S. exports and increase imports, and vice versa.

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A Shift in the Aggregate Demand Curve

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The aggregate supply curve shows the level of real GDP that the economy will produce at different possible price levels. The shape of the aggregate supply curve depends on the flexibility of prices and wages as real GDP expands and contracts. The aggregate supply curve has three ranges:

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(1) The Keynesian range of the curve is horizontal because neither the price level nor production costs will increase when there is substantial unemployment in the economy.

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(2) In the intermediate range, both prices and costs rise as real GDP rises toward full employment. Prices and production costs rise because of bottlenecks, the stronger bargaining power of labor, and the utilization of less productive workers and capital

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(3) The classical range is the vertical segment of the aggregate supply curve. It coincides with the full-employment output. Because output is at its maximum, increases in aggregate demand will only cause a rise in the price level.

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Full Employment

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Aggregate demand and aggregate supply analysis determines the equilibrium price level and the equilibrium real GDP by the intersection of the aggregate demand and the aggregate supply curves. In macroeconomic equilibrium, businesses neither overestimate nor underestimate the real GDP demanded at the prevailing price level.

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Stagflation exists when an economy experiences inflation and unemployment simultaneously. Holding aggregate demand constant, a decrease in aggregate supply results in the unhealthy condition of a rise in the price level and a fall in real GDP and employment.

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Cost-push inflation is inflation that results from a decrease in the aggregate supply curve while the aggregate demand curve remains fixed. Cost-push inflation is undesirable because it is accompanied by declines in both real GDP and employment.

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Cost Push Inflation

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Demand-pull inflation is inflation that results from an increase in the aggregate demand curve in both the classical and the intermediate ranges of the aggregate supply curve while the aggregate supply curve is fixed.

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Chapter 20 Quiz

©2000 South-Western College Publishing

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1. The aggregate demand curve is defined as a. the net national product.b. the sum of wages, rent, interest, and profits.c. the real GDP purchased at different possible

price levels.d. the total dollar value of household

expectations.

C. Answers a, b, and c are not real GDP purchases at different possible price levels during a time period.

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2. When the supply of credit is fixed, an increase in the price level stimulates the demand for credit, which, in turn, reduces consumption and investment spending. This effect is called the a. real balance effect.b. interest-rate effect.c. net exports effect.d. substitution effect.

B. At a high price level, the demand for borrowed money increases and results in higher cost of borrowing (interest rates). Higher interest rates result in lower consumption and investment spending.

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3. The real balance effect occurs because a higher price level reduces the real value of people’s a. financial assets.b. wages.c. unpaid debt.d. physical investments.

A. As price increase the dollars people receive in their paychecks and wealth are worth less. As a result, real GDP demand decreases.

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4. The net exports effect is the inverse relationship between net exports and the _______of an economy. a. Real GDP.b. GDP deflator.c. Price level.d. Consumption spending.

C. A higher domestic price level makes U.S. goods more expensive relative to foreign goods and vice versa.

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5. Which of the following will shift the aggregate demand curve to the left? a. An increase in exports.b. An increase in investment.c. An increase in government spending.d. A decrease in government spending.

D. Answers a, b, c shift the aggregate demand curve to the right.

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6. Which of the following will not shift the aggregate demand curve to the left?a. Consumers become more optimistic about

the future.b. Government spending decreases.c. Business optimism decreases.d. Consumers become pessimistic about the

future.

A. Answers b, c and d shift the aggregate demand curve leftward.

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7. The popular theory prior to the Great Depression that the economy will automatically adjust to achieve full employment is a. supply-side economics.b. Keynesian economics.c. classical economics.d. mercantilism.C. Supply-side economic concerns shifts in aggregate supply. Keynesians do not believe the economy automatically adjusts to full employment. Mercantilism is the idea that gold or silver is the source of a nation’s wealth.

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8. Classical economists believed that the a. price system was stable.b. goal of full employment was impossible. c. price system automatically adjusts the

economy to full employment in the long run.d. government should not attempt to restore

full employment.

C. This is a key assumption for the vertical shape of the classical aggregate supply curve.

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9. Which of the following is not a range on the eclectic or general view of the aggregate supply curve?a. Classical range.b. Keynesian range.c. Intermediate range.d. Monetary range.

D. Answers a, b, and c are the three district ranges of the aggregate supply at a level of real GDP below full employment.

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Full Employment

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10. Macroeconomic equilibrium occurs when a. aggregate supply exceeds aggregate demand.b. the economy is at full employment.c. aggregate demand equals aggregate supply.d. aggregate demand equals the average price

level.

C. Note that aggregate demand can equal aggregate supply at a level of real GDP below full employment.

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11. Along the classical or vertical range of the aggregate supply curve, a decrease in the aggregate demand curve will decrease a. both the price level and real GDP.b. only real GDP.c. only the price level.d. neither real GDP or the price level.

C. Along the vertical range of the aggregate supply curve, the economy is at full employment and only the price level changes.

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12. Other factors held constant, a decrease in resource prices will shift the aggregate a. demand curve leftward.b. demand curve rightward.c. supply curve leftward.d. supply curve rightward.

D. Changes in production costs do not affect the aggregate demand curve.

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13. Assuming a fixed aggregate demand curve, a leftward shift in the aggregate supply curve causes a (an)a. increase in the price level and a decrease in

real GDP.b. increase in the price level and an increase in

real GDP.c. decrease in the price level and a decrease in

real GDP.d. decrease in the price level and an increase in

real GDP.

A.

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Cost Push Inflation

AS2P

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14. An increase in the price level caused by a rightward shift of the aggregate demand curve is called a. cost-push inflation.b. supply shock inflation.c. demand shock inflation.d. demand-pull inflation.

D.

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15. Suppose workers become pessimistic about their future employment, which causes them to save more and spend less. If the economy is on the intermediate range of the aggregate supply curve, thena. both real GDP and the price level will fall.b. real GDP will fall and the price level will

rise. c. real GDP will rise and the price level will

fall.d. both real GDP and the price level will rise.A. A leftward movement of the aggregate

demand curve along a downward sloping aggregate supply curve will result in lower prices and less employment.

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