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Chapter 7

Aggregate Demand, Aggregate Supply,


and the Self-Correcting Economy

Answers to Questions in the Textbook

1.

In microeconomics, the demand curve shows the various quantities of a specific product that a
consumer wants at various prices for that product, holding preferences, income, and other prices
constant. The quantity demanded changes because of a change in relative prices. In macroeconomics,
the aggregate demand curve shows the various quantities of GDP demanded at various price levels in
the economy. Here, there is no change in relative prices of other products (although if the nominal
wage is unchanged, there is a change in the real wage, which is a relative price). In macroeconomics,
the increase in output demanded arises because the changing price level causes the real money supply
(and interest rates) to change.

2.

(a) The AD curve is steeper when the interest responsiveness of the demand for money becomes
larger. When the interest responsiveness of the demand for money becomes larger, the demand
for money curve will have a flatter slope relative to the M/P axis. A given increase in the real
money supply will therefore produce less of a reduction in the interest rate, less of an expansion
in autonomous planned spending, and less of an expansion in real GDP. Consequently, a given
reduction in the price level, which increases the real money supply, will have a smaller effect on
real GDP when the interest responsiveness of the demand for money is larger.
(b) The AD curve is flatter when the income responsiveness of the demand for money is larger
because the LM curve is steeper. A steep LM curve amplifies the effect on output of a higher real
money supply, all other things held equal.

3.

(a) Shifts LM curve to the right; therefore AD shifts to the right.


(b) Shifts IS curve to the right; therefore AD shifts to the right.
(c) Shifts horizontal intercept of the IS curve to the left and makes IS steeper; therefore, AD curve
shifts to the left and becomes steeper.
(d) Shifts vertical intercept of the IS curve down and makes IS curve flatter; effect on horizontal
intercept is ambiguous. Nevertheless, the AD curve shifts to the right and becomes flatter. For the
AD curve, it can be shown that Y/c > 0 if Y > Ta + tY.
(e) Makes IS pivot upward about its horizontal intercept, kAp, because the vertical intercept, Ap/b,
becomes larger as b becomes smaller. Therefore, AD shifts to the right and becomes steeper.
(f) Leaves the original IS curve unchanged (absent a real balance effect), but shifts the LM curve to
the left by decreasing the real money supply. Because the nominal money supply has not
changed, however, this causes a movement along the original AD curve, rather than a shift in it.
(g) Makes the IS curve shift to the right; therefore, AD curve shifts to the right.
(h) Makes net exports increase thus shifting the IS curve to the right; therefore, AD curve shifts
to the right.

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4.

The derivation of the aggregate supply curve depends on both a fixed labor demand curve and a fixed
nominal wage. Given the demand for labor, an increase in employment will necessarily reduce the
marginal product of labor. This in turn means that a firm will not hire additional labor unless the real
wage falls. A decrease in the real wage must be accomplished, therefore, with an increase in the price
level (P). Such a decrease would not be assured if the nominal wage (W) were to change. The
increase in labor employed, and hence in real output, when P increases and W remains fixed, is why
the aggregate supply curve is upward sloping.

5.

A point along the SAS curve where actual real GDP is less than natural real GDP corresponds to a
point on the labor demand curve in Figure 7.7 that is above the equilibrium real wage rate. Figure 7.7
also shows that at that real wage rate, the supply of labor exceeds the demand for labor. Therefore,
when actual real GDP is less than natural real GDP, workers are not working as much as they would
like. A similar argument would show that workers are working more than they would like at points
along the SAS curve where actual real GDP exceeds natural real GDP.

6.

(a)
(b)
(c)
(d)
(e)
(f)

7.

(a) The labor supply curve shifts left if concerns over homeland security reduce the amount of
immigration by workers willing to work for less than present American workers. The equilibrium
real wage rate increases as a result of the decrease in the supply of labor.
(b) The demand for labor shifts right since firms are willing to pay more to workers whose
productivity has increased as a result of improvements in education. The equilibrium real wage
rate increases as a result of the increase in the demand for labor.
(c) The labor demand curve shifts left since firms are not as willing to pay as much to workers when
their productivity declines. The equilibrium real wage rate declines as a result of the decrease in
the demand for labor.
(d) The supply of labor increases when the government cuts unemployment benefits because an
opportunity cost of working, namely collecting unemployment benefits, has declined in value.
The increase in the supply of labor reduces the equilibrium real wage rate.

8.

(a) Technological improvement rotates the production function counterclockwise around the origin
and shifts the labor demand curve outward. With the nominal wage rate fixed, employment is
higher and output is greater at each price level; hence, the SAS curve shifts to the right.
(b) The decrease in the nominal wage rate lowers the real wage at each price level. Hence, larger
employment and output levels occur at each price level and the SAS curve shifts to the right.
(c) The decline in nonlabor inputs rotates the production function clockwise around the origin and
shifts the labor demand curve inward. With the nominal wage rate fixed, employment and output
at each price level decline; hence, the SAS curve shifts to the left.

Increases.
No change.
Decreases.
Increases.
No change.
Increases.

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9.

Gordon

Macroeconomics, Tenth Edition

If the short-run aggregate supply curve is relatively flat, then a change in aggregate demand results
mainly in a change in output and only a small change in the price level, given the nominal wage rate.
Therefore, there is little change in the real wage rate, given the nominal wage rate. Furthermore, if the
demand for labor curve is relatively flat, it will not take much of a change in the nominal wage rate
relative to the price level to return the real wage to the equilibrium real wage rate. Therefore the price
level changes that result from the shifts of the SAS due to changes in the nominal wage should occur
at a rate that is similar to the rate of change in the nominal wage. If on the other hand, the SAS curve
is relatively steep, then a change in aggregate demand shows up mainly as a change in the price level,
resulting in a large change in the real wage rate, given the nominal wage rate. The same logic as
applied in the previous paragraph would show why there would need to be a large change in the
nominal wage rate relative to the price level necessary to restore that labor market to equilibrium if
the labor demand curve is relatively steep. Therefore the empirical observation that there are
relatively minor changes in the real wage rate over the course of a business cycle is more consistent
with relatively flat labor demand and short-run aggregate supply curves.

10. On the assumption that the AD curve is the same in both cases, the effect on the price level and output
would be the same. The composition of that output can differ, however. An increase in government
spending is likely to increase the interest rate and thus crowd out autonomous consumption spending
and autonomous investment. With flexible exchange rates, an increase in the interest rate will cause
the exchange rate to increase and there will also be a crowding out effect on net exports. An
expansionary monetary policy will tend to reduce interest rates, and therefore autonomous
consumption, investment, and net exports will be crowded in. An increase in government spending
will tend to increase both the budget deficit and the foreign trade deficit (imports will tend to rise,
exports will tend to fall). An increase in the nominal money supply will tend to reduce the budget
deficit because at the higher level of output greater tax revenues will be generated. The impact of an
increased money supply on the foreign trade deficit is uncertain. A higher level of income will
increase imports. As the exchange rate falls in response to the lower interest rate, however, imports
will fall while exports will increase. The net effect depends on the relative strength of these
responses.
11. (a) The answer to part a of question 11 is the same as in the ninth edition.(b) Real output and the
interest rate both the increase when net exports rise as a result of the depreciation in dollar. The
increase in real output and the rise in the interest rate are shown graphically as a shift right of the IS
curve and a movement up the LM curve. The aggregate demand curve shifts right by the amount that
income increases at the intersection of the new IS curve and the LM curve. The price level rises since
aggregate demand exceeds aggregate supply at the initial price level. The rise in the price level is
shown graphically as movements up the SAS and the new aggregate demand curve. The rise in the
price level reduces the real money supply, which is shown as a shift left of the LM curve and
corresponds to the movement up the new aggregate demand curve. Therefore real output, the interest
rate, and the price level all increase in the short run, while the real wage rate falls due to the rise in
the price level. Since the real wage rate is below the equilibrium real wage rate, the nominal wage
starts to rise as workers and firms negotiate new contracts. The rise in the nominal wage rate shifts
the SAS curve to the left, which results in a further rise in the price level but a decline in real output
which are shown graphically as a movement up the new aggregate demand curve. Corresponding to
this movement up the new aggregate demand curve is a shift left of the LM curve as the additional
increase in the price level leads to a further decline in the real money supply. The interest rate
continues to rise as the real money supply continues to decline. The price level, the interest rate, and
the nominal and real wage rates all continue to increase and real output continues to decline as the
SAS and LM curves continue to shift left until the SAS, the new AD curve, and the LAS curve all
intersect at the original level of real output, YN. So at the new long-run equilibrium, the effect of the
depreciation of the dollar is a higher price level, a higher nominal wage, an a higher interest rate, but
no change in the equilibrium real wage rate or real GDP.

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12. No. The economy is in short-run equilibrium when the AD and SAS curves intersect, but not
necessarily in long-run equilibrium. It will be a sustainable long-run equilibrium only if the economy
finds itself operating on both the labor demand curve and the labor supply curve. This occurs only
where the labor demand and labor supply curves intersect, so there is no pressure to change. At that
point the actual real wage equals the equilibrium real wage and Y = Y N . At any other combination of
W, P, and Y, the SAS curve will shift as expectations are adjusted.
13. The movement down the AD curve would result from falling prices in response to the economys being
below Y N . The parameter for the SAS curve is the nominal wage rate. If the SAS curve did not shift
(nominal wages did not fall), the falling price levels would yield real wages above the equilibrium real
wage. Thus, nominal wages must fall along with prices if the economy is going to self-correct. During
the Great Depression, nominal wages did not behave as the classical economists predicted: nominal
wages did not decline continuously during the 1930s when Y was below Y N ; in fact, in 1937 the nominal
wage rate was back to the 1929 level, despite an unemployment rate of 14 percent.
14. Monetary impotence refers to the situation when an increase in the real money supply does not
stimulate additional spending and output. The two conditions that would lead to monetary impotence
are a vertical IS curve or horizontal LM curve. Because of falling consumer and business confidence,
the IS curve during the depression was very steep. This suggests that changes in the interest rate
would have had very little effect on desired spending.
15. Unlike the United States, Britain allowed its foreign exchange to fall, resulting in a rise in net exports
and a relatively smaller decrease in aggregate demand. That relatively smaller decrease in aggregate
demand resulted in a less severe downturn in output in the United Kingdom than in the United States.
The German governments spending on armaments, highways, and housing resulted in a more
expansionary fiscal policy than the one pursued by the United States government and a relatively
smaller decrease in aggregate demand in Germany than in the United States. In addition, the German
government allowed prices and wages to fall, unlike the United States government which took
actions to raise wages and prices. Thus the actions of the German government allowed its economys
SAS curve to shift right, whereas the actions of the United States government caused the American
economys SAS curve to shift left. Therefore governmental policies towards wages and prices
moderated the severity of the Great Depression in Germany, whereas they exacerbated it in the
United States.
16.
17. A fall in prices, with a constant nominal money supply, leads to an increase in the real money supply.
With the Pigou effect, this increase in the money supply will directly affect the demand for
commodities; thus the AD curve cannot be vertical.
18. In a period of continuing inflation, the value of real balances would decline if the growth rate of the
nominal money supply was less than the inflation rate. This change in wealth might cause a decline in
autonomous expenditures, thus helping to slow the growth rate of output. Here, the expectations
effect might work against policymakers if people, expecting further inflation, decide to buy today
and beat the price increases. This activity would stimulate spending. Similarly, the redistribution
effect could work against policymakers if the winners from the inflation tended to spend at a greater
rate than losers.

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Macroeconomics, Tenth Edition

19. The initial impact of the increase in autonomous exports will be to shift both the IS and AD curves to
the right. Both output and prices would increase. Given the existence of a real balance effect, however,
the rising prices will cause the IS curve to shift backwards to the left along the (assumed) constant LM
curve. This implies a movement upward along the new AD curve. The economy will return
automatically to the intersection with the LAS line. If the expectations and redistribution effects are
present, then these will shift the AD curve to the right, exacerbating the rise in prices accompanying
the increase in autonomous exports.
20. If the nominal wage is rigid downward, the SAS curve will remain fixed. Even if the AD curve is
downward sloping, the price level can fall along the AD curve only until the AD curve intersects the
fixed SAS curve. As a result, a shift to the left by the AD curve will result in an output level below YN
and real wages above the equilibrium level.

Answers to Problems in Textbook

1.

(a) The equation of the IS curve is Y = kAp. Therefore the equation of the IS curve is Y = 2.5(5,200
200r) = 13,000 500r. Since the price level is 1.0, the real money supply equals 1,800/1.0.
Therefore the equation for the LM curve is Y = 5(1,800) + 500r = 9,000 + 500r. To compute the
equilibrium interest rate, set the equation for the IS curve equal to the equation for the LM curve
to get 13,000 500r = 9,000 + 500r. Adding 500r to and subtracting 9,000 from both sides yields
1,000r = 4,000. Dividing both sides by 1,000 yields the equilibrium interest rate, r = 4. To
compute equilibrium real output, substitute the equilibrium interest rate into the equations for the
IS and LM curves to get Y = 13,000 500(4) = 9,000 + 500(4) = 11,000.
(b) When the price level is 0.8, the real money supply equals 2,250. Therefore the equation for the
LM curve is Y = 5(2,250) + 500r = 11,250 + 500r. Setting the IS and LM curves equal to each
other and solving for r and Y yields that the equilibrium real output equals 12,125 and the
equilibrium interest rate equals 1.75 percent. When the price level is 1.2, the real money supply
equals 1,500. Therefore the equation for the LM curve is Y = 5(1,500) + 500r = 7,500 + 500r.
Setting the IS and LM curves equal to each other and solving for r and Y yields that the
equilibrium real output equals 10,250 and the equilibrium interest rate equals 5.5 percent. When
the price level is 2.0, the real money supply equals 900. Therefore the equation for the LM curve
is Y = 5(900) + 500r = 4,500 + 500r. Setting the IS and LM curves equal to each other and
solving for r and Y yields that the equilibrium real output equals 8,750 and the equilibrium
interest rate equals 8.5 percent.
The points on the aggregate demand curve are: (12,125, 0.8); (11,000, 1.0); (10,250, 1.2); and
(8,750, 2.0).
(c) Long-run equilibrium requires the nominal wage rate and the price level at which aggregate
demand and short-run aggregate supply are equal be such that the real wage rate equal the
equilibrium real wage rate in the labor market. Therefore the long-run aggregate supply curve is
vertical at natural real output, which in this problem equals 11,000. Therefore the long-run
equilibrium real output is 11,000, the long-run equilibrium price level is 1.0, and the long-run
equilibrium interest rate is 4 percent.
(d) The equation of the new IS curve is Y = 2.5(5,800 200r) = 14,500 500r. Setting the equation
for the new IS curve equal to the equations for the LM curves and solving for r and Y yields that:
at a price level of 0.8, the equilibrium real output equals 12,875 and the equilibrium interest
rate equals 3.25 percent; at a price level of 1.0, the equilibrium real output equals 11,750 and
the equilibrium interest rate equals 5.5 percent; at a price level of 1.2, the equilibrium real
output equals 11,000 and the equilibrium interest rate equals 7.0 percent; at a price level of 2.0,
the equilibrium real output equals 9,500 and the equilibrium interest rate equals 10.0 percent.

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65

The points on the new aggregate demand curve are: (12,875, 0.8); (11,750, 1.0); (11,000, 1.2);
and (9,500, 2.0).
(e) Since aggregate demand exceeds aggregate supply at a price level of 1.0, the price level
increases. Firms increase real output as the price level rises, which is a movement up the SAS
curve. The rise in the price level also reduces the real money supply which results in a movement
up the new AD curve. The price level continues to rise until aggregate demand and short-run
aggregate supply are equal. The real wage rate falls as the price level rises, given the nominal
wage rate.
(f) The decline in the real wage rate drives it below the equilibrium real wage rate. That causes the
nominal wage rate to rise as workers and firms negotiate new contracts. The rise in the nominal
wage shifts the SAS curve left, resulting is a further rise in the price level and a drop in real
output. The nominal wage rate and the price level continue to rise, while real output continues to
fall until the real wage rate equals the equilibrium real wage rate, which occurs when the new
AD curve, an SAS curve, and the LAS all intersect at natural real output, which in this problem
equals 11,000. The new long-run equilibrium price level is 1.2 and the new long-run equilibrium
interest rate is 7 percent.
2.

(a) The equation of the IS curve is Y = kAp. Therefore the equation of the IS curve is Y = 2(6,400
250r) = 12,800 500r. Since the price level is 0.8, the real money supply equals 2,400/0.8 =
3,000. Therefore the equation for the LM curve is Y = 4(3,000) + 500r = 12,000 + 500r. To
compute the equilibrium interest rate, set the equation for the IS curve equal to the equation for
the LM curve to get 12,800 500r = 12,000 + 500r. Adding 500r to and subtracting 12,000 from
both sides yields 1,000r = 800. Dividing both sides by 1,000 yields the equilibrium interest rate,
r = 0.8. To compute equilibrium real output, substitute the equilibrium interest rate into the
equations for the IS and LM curves to get Y = 12,800 500(0.8) = 12,000 + 500(0.8) = 12,400.
When the price level is 1.0, the real money supply equals 2,400. Therefore the equation for the
LM curve is Y = 4(2,400) + 500r = 9,600 + 500r. Setting the IS and LM curves equal to each other
and solving for r and Y yields that the equilibrium real output equals 11,200 and the equilibrium
interest rate equals 3.2 percent. When the price level is 1.2, the real money supply equals 2,000.
Therefore the equation for the LM curve is Y = 4(2,000) + 500r = 8,000 + 500r. Setting the IS and
LM curves equal to teach other and solving for r and Y yields that the equilibrium real output
equals 10,400 and the equilibrium interest rate equals 4.8 percent. When the price level is 2.0, the
real money supply equals 1,200. Therefore the equation for the LM curve is Y = 4(1,200) + 500r
= 4,800 + 500r. Setting the IS and LM curves equal to each other and solving for r and Y yields
that the equilibrium real output equals 8,800 and the equilibrium interest rate equals 8.0 percent.
The points on the aggregate demand curve are: (12,400, 0.8); (11,200, 1.0); (10,400, 1.2); and
(8,800, 2.0).
(b) Since the real wage rate equals the equilibrium real wage rate where the long-run and short-run
aggregate supply curve intersect at natural real output, we have that 10,400 = 10,400 25W +
1,000P at the equilibrium real wage rate. Subtracting 10,400 from and adding 25W to both sides
of the equation yields 25W = 1,000P at the equilibrium real wage rate. Dividing both sides of the
equation by 25 and the price level yields that the equilibrium real wage rate, W/P, equals 40.
(c) When the nominal wage rate equals 48, the equation for the SAS curve is Y = 10,400 25(48) +
1,000P = 10,400 1,200 + 1,000P = 9,200 + 1,000P. Therefore at price levels of 0.8, 1.0, 1.2,
and 2.0, business firms are willing to produce real output equal to 10,000, 10,200, 10,400, and
11,200, respectively.
The points on the SAS curve, given W = 48, are: (10,000, 0.8); (10,200, 1.0); (10,400, 1.2); and
(11,200, 2.0).

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Macroeconomics, Tenth Edition

(d) Aggregate demand and short-run aggregate supply are equal at a price level of 1.2. Therefore
equilibrium real output equals 10,400 and the equilibrium interest rate is 4.8 percent.
(e) At a price level of 0.8, the new real money supply equals 2,000/0.8 = 2,500. Therefore the
equation for the LM curve is Y = 4(2,500) + 500r = 10,000 + 500r. Setting the IS and LM curves
equal to each other and solving for r and Y yields that the equilibrium real output equals 11,400
and the equilibrium interest rate equals 2.8 percent. When the price level is 1.0, the real money
supply equals 2,000. Therefore the equation for the LM curve is Y = 4(2,000) + 500r = 8,000 +
500r. Setting the IS and LM curves equal to each other and solving for r and Y yields that the
equilibrium real output equals 10,400 and the equilibrium interest rate equals 4.8 percent. When
the price level is 1.2, the real money supply equals 1,666.67. Therefore the equation for the
LM curve is Y = 4(1,666.67) + 500r = 6,666.67 + 500r. Setting the IS and LM curves equal to
each other and solving for r and Y yields that the equilibrium real output equals 9,333.33 and the
equilibrium interest rate equals 6.13 percent. When the price level is 2.0, the real money supply
equals 1,000. Therefore the equation for the LM curve is Y = 4(1,000) + 500r = 4,000 + 500r.
Setting the IS and LM curves equal to each other and solving for r and Y yields that the
equilibrium real output equals 8,400 and the equilibrium interest rate equals 8.8 percent.
The points on the new aggregate demand curve are: (11,400, 0.8); (10,400, 1.0); (9,733.33, 1.2);
and (8,400, 2.0).
(f) The new aggregate demand curve intersects the short-run aggregate supply curve, given W = 48,
at a price level of 1.0413. Equilibrium real output equals 10,241.3 at that price level.
(g) The new aggregate demand curve intersects the vertical long run aggregate supply curve when
actual real output equals natural real output, which is 10,400 in this problem. The new long-run
equilibrium price level is 1.0 and the new long-run equilibrium interest rate is still 4.8. There is
no change in the interest rate in the long run because the price level declines in the same
proportion as the nominal money supply leaving the real money supply unchanged at 2,000.
The economy adjusts from the short-run equilibrium of part f as the nominal wage rate declines.
The nominal wage rate declines because the short-run fall in the price level from 1.2 to 1.0413
drives the real wage rate above the equilibrium real wage rate. Therefore, the workers and firms
negotiate new contracts that result in lower nominal wage rates. The SAS curve shifts right as the
nominal wage rate declines, resulting in a further drop in the price level, but a rise in real output.
The nominal wage rate and the price level continue to decline, and real output continues to
increase until the economy reaches its long-run equilibrium at a price level of 1.0 and real output
equal to 10,400.
In long-run equilibrium, the real wage rate equals the equilibrium real wage rate, which in this
problem equals 40. Since the new long-run equilibrium price level equals 1.0, the nominal wage
rate at the new long-run equilibrium equals 40 as well.
3.

(a) To calculate the equilibrium real wage rate, set the equations for the labor demand curve and
labor supply curve equal to one another to get 250 2(W/P) = 3(W/P). Adding 2(W/P) to both
sides of the equation yields 250 = 5(W/P). Dividing both sides by 5 yields that the equilibrium
real wage rate equals 50. Using either the equation for labor demand or the equation for labor
supply yields that the equilibrium quantity of labor equals 150.
(b) The real wage rate equals 60/1 = 60. Since the real wage rate is above the equilibrium real wage
rate, the price level is less than the price level that would equate aggregate demand with long-run
aggregate supply. Therefore actual real output is less than natural real output.
The change in aggregate demand must cause the price level to increase enough to reduce the real
wage rate to its equilibrium value of 50. Given the nominal wage rate equals 60, the price level
must increase from 1.0 to 1.2. For the price level to increase, given no change in the nominal
wage rate, the aggregate demand curve must shift to the right, meaning that policymakers took
actions to increase aggregate demand.

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(c) If the nominal wage rate equals 56 and the price level equals 1.4, then the real wage rate equals
56/1.4 = 40. Since the real wage rate is below the equilibrium real wage rate, the price level is
greater than the price level would equate aggregate demand with long-run aggregate supply.
Therefore actual real output exceeds natural real output.
If the long-run equilibrium price level is 1.6, given the aggregate demand curve, then for the real
wage rate to equal 50, its equilibrium value, the nominal wage rate must equal 80.
Since the real wage rate is below the equilibrium real wage rate, given W = 56 and P = 1.4,
workers and firms agree to an increase in the nominal wage rate. The increase in the nominal
wage rate results in a shift left of the SAS curve. That shift results in a rise in the price level and a
fall in real output. Real output continues to fall as the nominal wage rate and the price level
continue to rise until long-run equilibrium is reached at a price level of 1.6 and a nominal wage
rate of 80.
4.

(a) See problem 1 for the equation of the LM curve. The equation of the IS curve is Y = kAp.
Therefore the equation of the IS curve is Y = 2.5(4,600 + 600/P 200r) = 11,500 + 1,500/P
500r. Since the price level is 1.0, the equation of the IS curve is Y = 13,000 500r. Setting the IS
and LM curves equal to each other and solving for r and Y yields that the equilibrium real output
equals 11,000 and the equilibrium interest rate equals 4.0.
(b) See problem 1 for the equations of the LM curves. When the price level is 0.8, the equation of the
IS curve is Y = 11,500 + 1,500/0.8 500r = 13,375 500r. Setting the IS and LM curves equal to
each other and solving for r and Y yields that the equilibrium real output equals 12,312.5 and the
equilibrium interest rate equals 2.125. When the price level is 1.2, the equation of the IS curve is
Y = 11,500 + 1,500/1.2 500r = 12,750 500r. Setting the IS and LM curves equal to each other
and solving for r and Y yields that the equilibrium real output equals 10,125 and the equilibrium
interest rate equals 5.25. When the price level is 2.0, the equation of the IS curve is Y = 11,500 +
1,500/2.0 500r = 12,250 500r. Setting the IS and LM curves equal to each other and solving
for r and Y yields that the equilibrium real output equals 8,375 and the equilibrium interest rate
equals 7.75.
The points on the aggregate demand curve are: (12,312.5, 0.8); (11,000, 1.0); (10,125, 1.2); and
(8,750, 2.0).
(c) The aggregate demand curve in this problem is flatter than in part b of problem 1. Note that a
decrease in the price level from 1.0 to 0.8 causes real output to rise from 11,000 to 12,312.5 in
this problem, whereas the same drop in the price level causes real output to increase to only
12,125 in problem 1. Similarly a rise in the price level from 1.0 to 1.2 causes real output to
decline by 875 billion from 11,000 to 10,125 in this problem, whereas the decline is only 750
billion in problem 1 for the same price increase.
The reason why the Pigou effect results in a flatter aggregate demand curve is that a change in
the price level causes a change in autonomous spending. The change in autonomous spending
causes real output to increase and decrease by a larger quantity when the price level falls and
rises, respectively.