1. Suppose that the economy is in a long-run equilibrium.

a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate
demand, short-run aggregate supply, and long-run aggregate supply.
b. Now suppose that a stock-market crash causes aggregate demand to fall. Use your
diagram to show what happens to output and the price level in the short run. What
happens to the unemployment rate?
c. Use the sticky-wage theory of aggregate supply to explain what will happen to
output and the price level in the long run (assuming there is no change in policy).
What role does the expected price level play in this adjustment? Be sure to
illustrate your analysis in a graph.
2. Explain whether each of the following events will increase, decrease, or have no effect on the
long-run aggregate supply.
a. The United States experiences a wave of immigration.
b. Congress raises the minimum wage to $10 per hour.
c. Intel invents a new and more powerful computer chip.
d. A severe hurricane damages factories along the East Coast.
3. Suppose an economy is in long-run equilibrium.
a. Use the model of aggregate demand and supply to illustrate the initial equilibrium
(call it point A). Be sure to include both short-run and long-run aggregate supply.
b. The central bank raises the money supply by 5%. Use your diagram to show what
happens to output and the price level as the economy moves from the initial to the
new short-run equilibrium (call it point B).
c. Now show the new long-run equilibrium (call it point C). What causes the economy
to move from point B to point C?
d. According to the stick-wage theory of aggregate supply, how do nominal wages at
point A compare to nominal wages at point B? How do nominal wages at point A
compare to nominal wages at point C?
e. According to the sticky-wage theory of aggregate supply, how do real wages at
point A compare to real wages at point B? How do real wages at point A compare to
real wages at point C?
f. Judging by the impact of the money supply on nominal and real wages, is this
analysis consistent with the proposition that money has real effects in the short run
but is neutral in the long run?
4. Explain how each of the following developments would affect the supply of money, the
demand for money, and the interest rate. Illustrate your answers with a diagram.
a. The Federal Reserve raises the discount rate.
b. A wave of consumer pessimism reduces aggregate demand.
c. Banks begin to pay interest on all checkable deposits.
d. The Federal Reserve sells bonds in a open market operations.
e. Household income rises.
5. Suppose economists observe that an increase in government spending of $10 billion raises
the total demand for goods and services by $30 billion.
a. If these economists ignore the possibility of crowding out, what would they
estimate the marginal propensity to consume (MPC) to be?
b. Now suppose the economists allow for crowding out. Would their new estimate of
the MPC be larger or smaller than their initial one?
1.
a. The current state of the economy is shown in Figure 1. The aggregate-demand curve and
short-run aggregate-supply curve 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. 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, moving the economy back to the natural rate of output.

Figure 1.

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.
3.
a. The current state of the economy is shown in Figure 2. The aggregate-demand curve
and short-run aggregate-supply curve intersect at the same point on the long-run
aggregate-supply curve.
b. If the central bank increases the money supply, aggregate demand shifts to the right (to
point B). In the short run, there is an increase in output and the price level.
c. Over time, nominal wages, prices, and perceptions will adjust to this new price level. As
a result, the short-run aggregate-supply curve will shift to the left. The economy will
return to its natural rate of output (point C).
d. According to the sticky-wage theory, nominal wages at points A and B are equal.
However, nominal wages at point C are higher.
e. According to the sticky-wage theory, real wages at point B are lower than real wages at
point A. However, real wages at points A and C are equal.
 f. Yes, this analysis is consistent with long-run monetary neutrality. In the long run, an
increase in the money supply causes an increase in the nominal wage, but leaves the
real wage unchanged.

Figure 2.

4.
a. When the Federal Reserve raises the discount rate, the money-supply curve shifts to
the left from MS1 to MS2, as shown in Figure 3. The result is a rise in the interest rate.

Figure 3.

Figure 4.
 b. When a wave of consumer pessimism reduces aggregate demand, the money-demand
curve shifts to the left from MD 1 to MD2, as shown in Figure 4. The result is a decline in
the interest rate.
c. When banks begin to pay interest on all checkable deposits, the demand for money
increases, so the money-demand curve shifts to the right from MD 1 to MD 2, as
shown in Figure 5. The result is a rise in the interest rate.

Figure 5.

d. If the Federal Reserve sells bonds in open market operations, the money-supply curve
shifts to the left from MS 1 to MS2, as shown in Figure 3. The result is a rise in the
interest rate.
e. When household income rises, money demand increases from MD 1 to MD2 in Figure 5.
The increase in money demand increases the interest rate.
5.
a. If there is no crowding out, then the multiplier equals 1/(1 – MPC ). Because the
multiplier is 3, then MPC = 2/3.
b. If there is crowding out, then the MPC would be larger than 2/3. An MPC that is larger
than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by
the crowding-out effect.