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NSS Exploring Economics 5

Chapter 5

Determination of national income and price level (II) changes in AD and


AS

Questions
P.126
Think it over
1.
Do you know why real GDP changes all the time?
2.
What are the factors leading to a substantial increase in Hong Kongs real GDP after 2003?
P.127
Test yourself
5.1
What causes an upward movement along the aggregate demand curve?
P.128
Test yourself
5.2
What causes a leftward shift in the aggregate demand curve?

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Questions and Answers to Exercises (Chapter 5)

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P.129
Test yourself
5.3
Compare a movement along and a shift in the aggregate demand curve. Put either a or a
in the boxes.
Movement along the
aggregate demand
curve
Cause

Shift in the aggregate


demand curve

Change in the price level


Change in non-price
determinants

Effect

Change in aggregate
output demanded
Change in aggregate
demand

P.132
Discuss
5.1
How do the following events affect private consumption expenditure and subsequently the
aggregate demand curve? Circle the correct answer.
Effect on private
consumption expenditure

Effect on the aggregate


demand curve

a. An expected rise in
income

Shift leftwards / rightwards

b. An expected rise in price


level

Shift leftwards / rightwards

c. An income redistribution
from the rich to the poor

Shift leftwards / rightwards

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P.135
Discuss
5.2
How do the following events affect gross investment expenditure and the aggregate demand
curve? Circle the correct answers.
Effect on gross
investment expenditure

Effect on the aggregate


demand curve

a. A decrease in purchase
prices of capital

Shift leftwards / rightwards

b. An increase in operating
costs of capital

Shift leftwards / rightwards

c. More pessimistic
business prospects

Shift leftwards / rightwards

P.138
Test yourself
5.4
How do the following events affect the real value of our exports and/or imports as well as the
aggregate demand curve? Circle the correct answers.
Effect on the real
Effect on the real
value of our exports value of our
imports
a. An appreciation
of a foreign
currency against
our domestic
currency
b. Our trading
partner imposes a
unit tariff on our
exports
c. The price level of
our trading partner
decreases

No
direct
/ /
effect

No
direct
/ / effect

No
direct
/ /
effect

No
direct
/ /
effect

No
/ / direct
effect

No
/ / direct
effect

NSS Exploring Economics 5


Questions and Answers to Exercises (Chapter 5)

Effect on the aggregate


demand curve

Shift leftwards / rightwards

Shift leftwards / rightwards

Shift leftwards / rightwards

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NSS Exploring Economics 5


Questions and Answers to Exercises (Chapter 5)

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P.141
Test yourself
5.5
Compare a movement along and a shift in the aggregate supply curves. Put either a or a
in the table.
Movement along the
aggregate supply
curves
Cause

Shift in the aggregate


supply curves

Change in the price level


Change in non-price
determinants

Effect

Change in aggregate
output supplied
Change in aggregate
supply

P.146
Test yourself
5.6
What are the effects of the following events on the short run and long run aggregate supply
curves? Fill in the table below.
SRAS curve

LRAS curve

a. More workers have


received tertiary
education
b. A flood spoils a large
piece of farmland
c. The government reduces
the sales tax from 10% to
5%
d. A new generation of
computers is invented

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Questions and Answers to Exercises (Chapter 5)

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P.148
Test yourself
5.7
What are the short run and the long run effects of a decrease in the aggregate demand? Use a
diagram to illustrate your answer.
P.149
Test yourself
5.8
What are the short run and the long run effects of a decrease in the short run aggregate
supply? Use a diagram to illustrate your answer.
P.151
Test yourself
5.9
What are the short run and long run effects of a decrease in both the short run aggregate
supply and the long run aggregate supply? Use a diagram to illustrate your answer.
P.153
Test yourself
5.10
To raise the output level, should we increase or decrease the employment level of factors of
production under each of the following conditions?
a. The technology level remains unchanged.
b. There is a technological advancement.

P.158-159
Exercises
Multiple Choice Questions
1.
An increase in the aggregate demand is
A. caused by a fall in the price level.
B. caused by a rise in the aggregate output demanded.
C. represented by a downward movement along the aggregate demand curve.
D. represented by a rightward shift in the aggregate demand curve.

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2*.
Which of the following events can raise private consumption expenditure?
A. The price level is expected to drop in the near future.
B. The economy suffers from recession.
C. People are expected to have a longer lifespan.
D. The government raises unemployment benefits.
3.
The aggregate demand curve shifts leftwards when
A. the government raises income taxes.
B. firms expect a better business prospect in the coming few years.
C. the government starts to construct the Kai Tak Cruise Terminal.
D. Microsoft Corporation launches Windows 7 worldwide.
4.
Which of the following about the short run and long run aggregate supply curves is
INCORRECT?
A. The short run aggregate supply curve is upward sloping while the long run aggregate
supply curve is vertical.
B. The short run aggregate supply curve cuts the long run aggregate supply curve where the
aggregate output supplied is at the full employment level.
C. Both the short run and long run aggregate supply curves cannot produce an output level
greater than the full employment real GDP.
D. Both the short run and long run aggregate supply curves relate the aggregate output
supplied to the price level.
5*.
Which of the following events would shift the short run aggregate supply curve to the left?
A. The world prices of natural resources drop.
B. The economy gradually recovers from the damage of a natural disaster.
C. The government rebates half of its income taxes to taxpayers.
D. The government imposes green taxes.
6.
Which of the following shifts both the short run and long run aggregate supply curves to the
right?
A. Workers strike for better working conditions.
B. More and more people have higher education and professional training.

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C. Many people desire to retire earlier.


D. People become more and more wealthy.
7.
An increase in the aggregate demand would
A. raise the price level in both the short run and the long run.
B. raise the real GDP in both the short run and the long run.
C. raise the input prices in the short run but not in the long run.
D. All of the above.
8*.
A drop in real national income together with a rise in the price level is caused by
A. an increase in the aggregate demand.
B. a decrease in the aggregate demand.
C. an increase in the long run aggregate supply.
D. a decrease in the long run aggregate supply.
9*.
The long run effect on the price level is indeterminate if
A. both the aggregate demand and the long run aggregate supply increase.
B. the aggregate demand increases but the long run aggregate supply decreases.
C. the aggregate demand decreases but the long run aggregate supply increases.
D. both the aggregate demand and aggregate supply decrease by the same extent.

Short Questions.
1. Both the price level and non-price determinants can affect the aggregate output demanded.
Why does the former cause a movement along the aggregate demand curve while the latter
bring a shift in the curve?
(6 marks)
2**. A student says, When I plot the real GDP figures against the GDP deflator figures of
Hong Kong in the past 20 years, I cannot sketch any downward-sloping or upward-sloping
lines. There is no aggregate demand or aggregate supply curves in the real world.
Is he correct? Explain.
(6 marks)

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Structured Questions.
1.
What are the effects of the following events on the real national income and price level?
Use diagrams to illustrate.
a. Increase in both the aggregate demand and long run aggregate supply
(9 marks)
b. Decrease in both the aggregate demand and long run aggregate supply
(9 marks)
c. Increase in the aggregate demand but decrease in the long run aggregate supply (4 marks)
d. Decrease in the aggregate demand but increase in the long run aggregate supply (4 marks)
2. Use the AS-AD model to predict the short run and long run effects of the following events
on the real GDP and price level of Hong Kong.
a. The United States suffers a severe depression (with a negative real GDP growth rate).
(10 marks)
b. The Hong Kong government grants more transfer payments to improve the welfare of the
poor.
(10 marks)
c. Education reforms help improve Hong Kongs human capital.
(10 marks)
d. An earthquake destroys many infrastructures of the economy.
(10 marks)

Answers
P.126
Think it over
1. Due to changes in the aggregate demand and/or aggregate supply
2. Due to increases in both the aggregate demand and aggregate supply
P.127
Test yourself
5.1
An upward movement along the aggregate demand curve is caused by a rise in the price
level.
P C, I and (X M) Y Upward movement along the same AD Curve

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P.128
Test yourself
5.2
A change in a non-price determinant of the AD that reduces C, I, G or (X M) Aggregate
output demanded decreases at the same price level Leftward shift in the AD curve
P.129
Test yourself
5.3
Movement along the
aggregate demand
curve
Cause

Effect

Shift in the aggregate


demand curve

Change in the price level

Change in non-price
determinants

Change in aggregate
output demanded

Change in aggregate
demand

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P.131
Discuss
5.1
Effect on
private
consumption
expenditure

Effect on the
aggregate
demand curve

Explanation

a. An expected
rise in
income

Shift leftwards /
rightwards

People prefer to even out their


consumption level over time.
When future income is
expected to rise, although
present income remains
unchanged, people raise both
their present and future
consumption so as to have a
more even consumption level
over time.

b. An expected
rise in price
level

Shift leftwards /
rightwards

Consuming before the price


rise can save money.

c. An income
redistribution
from the rich
to the poor

Shift leftwards /
rightwards

The poor (rich) consume more


(less). Since the poor tend to
consume a larger proportion of
their disposable income than
the rich, total
consumption rises.

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P.135
Discuss
5.2
Effect on
gross
investment
expenditure

Effect on the
aggregate
demand curve

Explanation

a. A decrease in
purchase
prices of capital

Shift leftwards /
rightwards

Cost of acquiring capital


decreases and it is more
profitable to invest.

b. An increase in
operating
costs of capital

Shift leftwards /
rightwards

Net profit decreases and


it is less profitable to
invest.

c. More
pessimistic
business
prospects

Shift leftwards /
rightwards

Future profits are


expected to fall and it is
less profitable to invest.

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P.138
Test yourself
5.4
Effect on the real Effect on the real
value of our
value of our
exports
imports
a. An
appreciation
of a foreign
currency
against our
domestic
currency

b. Our
trading
partner
imposes a
unit tariff on
our exports
c. The price
level of our
trading
partner
decreases

No
direct
/ /
effect

No
direct
/ /
effect

No
direct
/ /
effect

No
direct
/ /
effect

No
direct
/ /
effect

No
direct
/ /
effect

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Questions and Answers to Exercises (Chapter 5)

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Effect on the
aggregate
demand
curve
Shift
leftwards /
Rightwards

Shift
leftwards /
Rightwards

Shift
leftwards /
Rightwards

Explanation

We need more
domestic
currency to buy
foreign goods
while foreigners
need less
foreign
currency to buy
ours.
Quantity of our
exports drops.

Foreign
products
become cheaper
relative to our
products.

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P.141
Test yourself
5.5
Movement along the
aggregate supply
curves
Cause

Effect

Shift in the aggregate


supply curves

Change in the price level

Change in non-price
determinants

Change in aggregate
output supplied

Change in aggregate
supply

P.146
Test yourself
5.6
a. More workers have
received tertiary
education
b. A flood spoils a
large piece of
farmland
c. The government
reduces the sales
tax from 10% to
5%
d. A new generation
of computers is
invented

SRAS curve
Shifts
rightwards

LRAS curve
Shifts rightwards

Explanation
Improvement in
labour quality.

Shifts leftwards

Unchanged

Shifts
rightwards

Unchanged

The flood creates


short-term adverse
effects
The reduction in sales
tax lowers production
costs.

Shifts
rightwards

Shifts rightwards

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Improvement in
technology

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P.148
Test yourself
5.7 A decrease in the aggregate demand

A decrease in
AD

Change in the
equilibrium point

Effect on the
equilibrium price
level

Effect on the
equilibrium real
national income

In the short run

AB

Decreases
(P1 PS2)

Decreases
(Y1 YS2)

In the long run

AC

Decreases
(P1 = PL2)

Remains unchanged
(Y1 = YL2 = Yf)

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P.149
Test yourself
5.8 A decrease in the short run aggregate supply

A decrease in
SRAS

Change in the
equilibrium point

Effect on the
equilibrium price
level

Effect on the
equilibrium real
national income

In the short run

AB

Increases
(P1 PS2)

Decreases
(Y1 YS2)

In the long run

No change (A = A)

Remains unchanged
(P1 = PL2)

Remains unchanged
(Y1 = YL2 = Yf)

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P.151
Test yourself
5.9 A decrease in both the short run aggregate supply and the long run aggregate supply

A decrease in
both
SRAS and
LRAS

Change in the
equilibrium point

Effect on the
equilibrium price
level

Effect on the
equilibrium real
national income

In the short run

AB

Increases
(P1 PS2)

Decreases
(Y1 = Yf1 YS2)

In the long run

AC

Increases
(P1 PL2)

Decreases
(Y1 YL2 = Yf2)

P.153
Test yourself
5.10
a. If the technology level remains unchanged, to raise the output level, we have to increase
the employment level of factors of production.
b. If there is a technological advancement, to increase the output level, we may or may
not increase the employment level of factors of production. If the percentage increase
in productivity occasioned by the technological advancement is larger (smaller) than
percentage increase in the output level, employment drops (rises). If they are equal, the
employment level remains unchanged.

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P.158-159
Exercises
Multiple Choice Questions
1. D
Option B is incorrect. It is the result, instead of the cause.
2.

D
Option A is incorrect. C because later consumption can save money.
Option B is incorrect. C because a recession lowers disposable income for many
people.
Option C is incorrect. C because people have to save more money for retirement.
Option D is correct. C because the policy raises the disposable income of the
unemployed.

3.

A
Option A is correct. Income taxes Disposable income C AD curve shifts
leftwards.
Options B, C and D are incorrect. They all raise the fixed gross investment expenditure.
The AD curve shifts rightwards.

4.

C
The SRAS curve is upward sloping. AQs may exceed Yf in the short run.

5.

D
Option A is incorrect. A drop in input prices shifts the SRAS curve rightwards.
Option B is incorrect. The recovery from damage raises the AQs and shifts the SRAS
curve rightwards.
Option C is incorrect. The rebate raises taxpayers disposable income and hence private
consumption expenditure. Hence the AD curve shifts rightwards.
Option D is correct. The policy raises production costs and shifts the SRAS curve
leftwards.

6.

B
Option A is incorrect. The strike is a negative supply shock with temporary effects. It
will only shift the SRAS leftwards.

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Option B is correct. As the quality of labour improves, labour becomes more productive.
Hence, both curves shift rightwards.
Option C is incorrect. The case reduces the labour force and shifts both curves leftwards.
Option D is incorrect. The case raises private consumption expenditure and shifts the
AD curve rightwards.
7.

A
Option C is incorrect. Input prices rise in both the short run and long run. In the long
run, if input prices do not rise by the same percentage as output prices, the real incomes
of input suppliers drop. Then, they would supply fewer inputs and aggregate output
drops.

8.

D
Option A is incorrect. AD Y and P in the short run;
Y remains unchanged and P in the long run
Option B is incorrect. AD Y and P in the short run;
Y remains unchanged and Pin the long run
Option C is incorrect. LRAS Y and P in the long run
Option D is correct. LRAS Y and P in the long run

9.

A
Option A is correct. Y (= new Yf) increases but change in P is uncertain.
Option B is incorrect. Y (= new Yf) decreases but P increases.
Option C is incorrect. Y (= new Yf) increases but P decreases.
Option D is incorrect. Y (= new Yf) decreases but P remains unchanged.

Short Questions
1.
The aggregate demand curve describes the aggregate outputs demanded at different price
levels, holding other factors constant. Hence, when the price level changes, the change in AQd
is described by the AD curve. By moving along the AD curve to the new price level, we can
find the new AQd. (3 marks)
However, when a non-price determinant changes, AQd changes at the same price level.
Hence, the new equilibrium is not on the original AD curve. The change brings a shift in the
AD curve. (3 marks)

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2.
The historical data show the equilibrium real GDP and GDP deflator of different periods of
time. In other words, each pair of figures showed the intersection point of AD and SRAS
during each period of time. (2 marks)
Since both the AD curve and the SRAS curve may shift during different periods of time, the
intersection points probably do not move along any single AD curve or SRAS curve. Hence,
when we plot the data onto a diagram, we would likely see a mess of scattered points, instead
of downward-sloping or upward-sloping lines. (4 marks)
(The following is a diagram plotting Hong Kongs real GDP figures against the GDP deflator
figures from 1989 to 2008. This is for reference only, no marks will be deducted for not
showing this diagram. )

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Structured Questions.
1 a. When both the AD and LRAS increase, the (full employment) real national income must
increase but the change in the price level is uncertain.
If AD (from AD1 to AD2) < LRAS Yf and P (from P1 to P2) (2 marks)
If AD (from AD1 to AD3) = LRAS Yf and P remains unchanged (P1 = P3)
(2 marks)
If AD (from AD1 to AD4) > LRAS Yf and P (from P1 to P4) (2 marks)

1 b. When both the AD and LRAS decrease, the (full employment) real national income must
decrease but the change in the price level is uncertain.
If AD (from AD1 to AD2) < LRAS Yf and P (from P1 to P2) (2 marks)
If AD (from AD1 to AD3) = LRAS Yf and P remains unchanged (P1 = P3)
(2 marks)
If AD (from AD1 to AD4) > LRAS Yf and P (from P1 to P4) (2 marks)

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1 c. When the AD increases but the LRAS decreases, the (full employment) real national
income decreases but the price level increases. (2 marks)

d. When the AD decreases but the LRAS increases, the (full employment) real national
income increases but the price level decreases. (2 marks)

2 a. When the United States suffers a severe depression, the real national income of the
United States decreases significantly. Hence the quantity of our exports to the United
States drops, aggregate output demanded decreases and our AD curve shifts leftwards. (2
marks)
The short run equilibrium is represented by B, at which the new AD curve intersects the
SRAS curve. In the short run, both the real national income and the price level decrease.
(2 marks)
The long run equilibrium is represented by C, at which the new AD curve intersects the
LRAS curve (achieved by shifting of SRAS from SRAS1 to SRAS2). In the long run, the

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real national income remains unchanged at the initial full employment level and the
price level decreases. (2 marks)

2 b When the Hong Kong government grants more transfer payments to the poor, the
disposable income of the poor increases. Hence private consumption expenditure
increases and the AD curve shifts rightwards. (2 marks)
The short run equilibrium is represented by B, at which the new AD curve intersects the
SRAS curve. In the short run, both the real national income and the price level increase.
(2 marks)
The long run equilibrium is represented by C, at which the new AD curve intersects the
LRAS curve (achieved by shifting of SRAS from SRAS1 to SRAS2). In the long run, the
real national income remains unchanged at the initial full employment level and the
price level increases. (2 marks)

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2 c. The education reforms raise the quality (productivity) of workers. Hence both the SRAS
and LRAS curves shift rightwards.(2 marks)
The short run equilibrium is represented by B, at which the AD curve intersects the new
SRAS curve. In the short run, the real national income increases while the price level
decreases. (2 marks)
The long run equilibrium is represented by C, at which the AD curve intersects the new
LRAS curve (achieved by shifting of SRAS from SRAS2 to SRAS2). In the long run,
the real national income increases while the price level decreases. (2 marks)

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2 d. The destruction reduces the amount of social capital and hence the productivity of the
economy. Hence, both the SRAS and LRAS curves shift leftwards. (2 marks)
The short run equilibrium is represented by B, at which the AD curve intersects the new
SRAS curve. In the short run, the real national income decreases while the price level
increases. (2 marks)
The long run equilibrium is represented by C, at which the AD curve intersects the new
LRAS curve (achieved by shifting of SRAS from SRAS2 to SRAS2). In the long run,
the real national income decreases while the price level increases. (2 marks)

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