Macroeconomics 9th Edition Boyes Solutions Manual

Macroeconomics 9th Edition Boyes
Solutions Manual
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CHAPTER 8
(MACRO CHAPTER 8)
Macroeconomic Equilibrium: Aggregate

Demand and Supply
FUNDAMENTAL QUESTIONS
1. What factors affect aggregate demand?
2. What causes the aggregate demand curve to shift?
3. What factors affect aggregate supply?
4. Why does the short-run aggregate supply curve become steeper as real GDP increases?
5. Why is the long-run aggregate supply curve vertical?
6. What causes the aggregate supply curve to shift?
7. What determines the equilibrium price level and real GDP?
OVERVIEW AND OBJECTIVES

The primary purpose of this chapter is to introduce the aggregate demand and supply model. This is the
second major macroeconomic model developed in the book.
The unique features of the chapter include the development of the aggregate demand curve from its
foundation in the aggregate expenditures curve. The chapter also shows the factors that cause the
aggregate demand curve to shift. The aggregate supply curve is also developed, and the short-run
aggregate supply curve is distinguished from the supply curve that exists in the long run.
After reading and reviewing this chapter, the student should be able to:
1. Define aggregate demand and aggregate supply.
2. Show how business cycles result from changes in aggregate demand and aggregate supply.
3. List factors that affect consumption, investment, government spending, and net exports.
4. Explain the wealth effect, the interest rate effect, and the international trade effect as reasons for a
downward-sloping aggregate demand curve.
5. List nonprice determinants that cause the aggregate demand curve to shift.
6. Explain differences in the short-run and long-run aggregate supply curves.
7. List nonprice determinants that cause the aggregate supply curve to shift.
8. Show how aggregate demand and aggregate supply equilibrium is determined.
Copyright © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or
in part.
50 Chapter 8: Macroeconomic Equilibrium: Aggregate Demand and Supply
KEY TERM REVIEW

demand-pull inflation
cost-push inflation
wealth effect
interest rate effect
international trade effect
aggregate demand curve
aggregate supply curve
long-run aggregate supply curve (LRAS)
LECTURE OUTLINE AND TEACHING STRATEGIES

I. Aggregate Demand, Aggregate Supply, and Business Cycles
Teaching Strategy: Be careful using the supply and demand analogy here. If you don’t push it
too far, using information that the students already know about market models can help introduce
aggregate supply and demand, but they should not get the impression that the macro model is just
the sum of individual markets. The underlying arguments in both cases are distinct.
A. Aggregate demand and business cycles: An increase in aggregate demand can cause real
GDP to rise, illustrating the expansionary phase of the business cycle and demand-pull
inflation. Recessions can occur when aggregate demand falls, thereby reducing equilibrium
real GDP.
B. Aggregate supply and business cycles: A reduction in aggregate supply can cause
equilibrium real GDP to fall and the price level to increase, an example of cost-push
inflation.
C. A look ahead: The reasons for the shapes and movements of the AD and AS curves are
different from those that explain the shapes and movements of the supply and demand
curves.
II. Factors That Influence Aggregate Demand

A. Consumption: Consumption spending depends on income, wealth, expectations,
demographics, and taxes.
B. Investment: Investment depends on factors that determine its profitability, including the
interest rate, technology, cost of capital goods, and capacity utilization.
C. Government spending: Government spending is a key tool of fiscal policy because it can be
set by government officials independent of the level of income.
Teaching Strategy: Show that government spending includes not only spending at the
federal level but also state and local government spending.
D. Net exports: Net exports are determined by income, domestic versus foreign prices,
exchange rates, and government trade policies.
E. Aggregate expenditures: Aggregate expenditures are the sum of all spending on domestic
goods and services.
Teaching Strategy: Point out that aggregate expenditures form the foundation for the
aggregate demand curve that will be discussed in the forthcoming section. Later you can
show how changes in aggregate expenditure components shift the aggregate demand curve.
Copyright © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
Chapter 8: Macroeconomic Equilibrium: Aggregate Demand and Supply 51
III. The Aggregate Demand Curve

The aggregate demand curve shows aggregate demand in relation to the price level.
A. Why the aggregate demand curve slopes downward
Teaching Strategy: Note that the arguments that were used to establish a downward-
sloping market demand curve do not make sense for an aggregate demand curve because
market quantities respond to relative price changes, while aggregate quantities respond to
general price changes.
1. The wealth effect: A price change causes the real value of wealth to change, resulting
in a change in spending.
2. The interest rate effect: When prices go up, people need more money to make their
purchases. They sell bonds to raise money, the supply of bonds increases, the price of
the bonds falls, and the interest rate on the bonds increases. Higher interest rates then
lead to lower investment and consumption.
3. The international trade effect: A change in domestic prices relative to foreign prices
can cause net exports to change.
4. The sum of the price-level effects: A lower (higher) price level leads to higher (lower)
consumption, investment, and net exports.
B. Changes in aggregate demand: Nonprice determinants
Teaching Strategy: Make certain that your students distinguish between movement along
an aggregate demand curve and a shift in the curve.
1. Expectations
2. Foreign income and price levels
3. Government policy
IV. Aggregate Supply

The positive relationship between price and national output is due to changes in profits.
A. Why the aggregate supply curve slopes upward—In the short run, resource prices are
assumed to be constant, so an increase in product prices leads to an increase in profits and
production.
B. Short-run versus long-run aggregate supply: In the long run, all costs are variable, so there is
no variation in the level of real output with the price level.
Teaching Strategy: Point out actual cases where prices will not rise as demand rises (for
example, major fast-food chains). Provide examples where prices rise concurrently with
increases in demand. Ask your students why businesses may not want to change prices when
demand changes.
1. Short-run aggregate supply curve: As the level of real GDP increases, the slope of the
aggregate supply curve becomes steeper.
Teaching Strategy: When you are discussing the shape of the aggregate supply curve,
note that, at any particular time, industries across the economy are producing at many
different levels relative to their capacity. Hence, when demand increases, some
industries will be able to increase production, while others will quickly approach full
capacity and will increase prices instead of production. As the economy approaches its
potential level of output, more industries are at full capacity and raise prices in
response to demand increases.
2. Long-run aggregate supply curve: In the long run, production costs fully adjust to price
increases. As a result, there is no variation in profits as prices change and thus no
variation in real output.
in part.
C. Changes in aggregate supply: Nonprice determinants

1. Resource prices
2. Technology
3. Expectations: Expectations, especially as they affect wage demands, are critical in
determining the position of the aggregate supply curve.
Teaching Strategy: Emphasize the role of expectations in shifting the aggregate
supply curve. This will be important when the relationship between the long-run and
short-run aggregate supply curve is discussed.
4. Economic growth: Long-run aggregate supply shifts—The long-run aggregate supply
curve shifts right over time as the potential output of the economy increases.
V. Aggregate Demand and Supply Equilibrium

A. Short-run equilibrium: When the short-run aggregate supply curve intersects the aggregate
demand curve, the economy is at a short-run equilibrium price and output level.
B. Long-run equilibrium: The long-run level of output is determined by the quantities of capital
and labor and the level of technological development in the economy.
OPPORTUNITIES FOR DISCUSSION

1. Compare the concepts of supply and demand at the micro and macro levels.
2. Discuss the latest recession in terms of the aggregate supply and demand framework. What
supply-side factors may have influenced the recession?
3. What measures have been taken to increase demand in the recent recession? Did these measures
actually work? Why or why not?
4. Why do we have two aggregate supply curves?
5. Why is the long-run aggregate supply curve fixed at the natural level of output and not at some
other output level?
6. What role does Ben S. Bernanke play in influencing business cycles?
7. Are there times in U.S. history when slowdowns in the economy are preferable?
ANSWERS TO EXERCISES
1. The aggregate demand curve differs from the demand curve for an individual good because the
aggregate demand curve is the demand curve for total output. In other words, the slope of the
aggregate demand curve does not depend on the substitution effect. Also, the demand for total
output is a function of the general price level instead of an individual product’s price.
2. The aggregate demand curve slopes down because of three effects. First, when the price level
increases, people’s real wealth declines. This wealth effect leads to a reduction in the aggregate
demand for output. Second, when the price level increases, the real value of the money supply
decreases. This leads to an increase in interest rates, which results in a reduction in the aggregate
demand for output. Third, when the price level increases relative to foreign prices, net exports fall,
which results in a smaller level of aggregate demand for output.
3. The foreign demand for U.S. produced goods and services increases when foreign income
increases. This leads to an increase in aggregate expenditures and aggregate demand (see figure).
4. If foreign prices fall, the demand for foreign produced goods and services will increase. Domestic
exports will decrease because of higher relative domestic prices. As a result, aggregate
expenditures and aggregate demand fall.
5. The aggregate supply curve differs from the supply curve for an individual good because the
former relates the quantity supplied of aggregate output, rather than individual good output, to the
general price level rather than to an individual price.
6.
a. When the technology of an economy improves, the aggregate supply curve shifts right.
When resource prices increase, the aggregate supply curve shifts to the left because profits
are smaller at each price level. When expected prices are higher, and labor negotiates a
higher wage today, the aggregate supply curve shifts to the left.
in part.
b.
The aggregate supply curve shifts right (from AS1 to AS 2 ) when resource prices fall or
technology improves, and shifts left (from AS1 to AS3 ) when price expectations increase and
wages rise as a result.
7.
a.
In the short run, resource costs are fixed so that a higher price level causes profits to rise and
induces firms to expand production. The closer we get to capacity output, the less output
rises given a price level rise, so the curve gets steeper as more and more firms reach their
maximum short-term output.
b.
The LRAS is drawn at the potential level of real GDP, Yp , which exists when the natural rate
of unemployment is reached. If the unemployment rate falls below the natural rate, then
output will rise beyond Y p , so SRAS can lie to the right of LRAS .
8.
a.
When aggregate demand falls, the economy moves along the aggregate supply curve to a
new equilibrium: P2 and Y2 .
b. In the short run, an equilibrium below potential Y can exist, but when people correct their
price expectations, the short-run aggregate supply curve shifts right to restore equilibrium at
potential Y0 .
in part.
9.
a.
When U.S. gross domestic product falls, the net exports of Japan also fall, thereby leading to
a leftward shift in the aggregate demand curve.
b.
When prices in Korea fall, Japanese goods become relatively more expensive. This leads to
a reduction in Japanese net exports and a leftward shift in the aggregate demand curve.
c.
If labor receives a large wage increase, the aggregate supply curve shifts to the left.
d.
If economists predict higher prices next year, price expectations cause resource prices to rise
now. This leads to a leftward shift in the aggregate supply curve. Expected higher prices also
cause current expenditures to increase, resulting in the aggregate demand curve shifting to
the right.
10. The economy is producing at the potential level of real GDP when its productive capacity is
operating at its most efficient level—less than 100 percent capacity. In the short run, the economy
could be producing at a level of capacity utilization greater than this efficient point.
in part.
11.
a. Equilibrium real GDP rises; the new price level is indeterminate.
b. Equilibrium price level rises; the new level of real GDP is indeterminate.
c. Equilibrium real GDP falls; the new price level is indeterminate.
d. Equilibrium price level falls; the level of real GDP is indeterminate.
12. AD must decrease relative to AS :
13. A horizontal AS has the price level fixed:
14. With a vertical AS curve, real GDP is unchanged:
15.
a. Consumption spending falls so AD falls:
Both equilibrium price level and real GDP fall.
in part.
b. Net exports rise so AD rises:
Both equilibrium price level and real GDP rise.

c. Net exports fall so AD falls:
Both equilibrium price level and real GDP fall.
d. Government spending increases so AD rises:
Both equilibrium price level and real GDP rise.

e. Higher wages shift AS to the left:
Equilibrium price level rises and equilibrium real GDP falls.

f. Technological advance shifts AS to the right:
Equilibrium price level falls and equilibrium real GDP rises.
in part.
16. As stock prices rise, the value of these assets increases household wealth. An increase in
household wealth increases consumption and thereby increase aggregate spending. An increase in
aggregate spending shifts the AD curve to the right, causing the equilibrium level of real GDP to
increase.
17. When the price of oil, an important resource in many industries, goes up, aggregate supply falls.
When aggregate supply falls, the equilibrium level of real GDP falls. Unless other factors change
to contribute to economic growth, the higher oil price reduces the productive capacity of the
economy.
18. Student answers will vary based on article chosen.
ANSWERS TO STUDY GUIDE HOMEWORK

1. Wealth effect, interest rate effect, international trade effect
2. Consumption, investment, government spending, net exports
3. Resource prices, technology, expectations
4.
Horizontal: unemployed resources allow firms to expand production without paying more
for resources.
Rising: as more and more sectors of the economy approach capacity, firms must pay higher
prices to attract additional resources.
Vertical: no more output can be produced, even at higher prices.
5.
a.
(1) Price level increases; real GDP increases
(2) Price level remains the same; real GDP decreases
(3) Price level increases; real GDP increases
(4) Price level remains the same; real GDP decreases
b.
(1) Price level increases; real GDP remains the same
(2) Price level decreases; real GDP decreases
(3) Price level increases; real GDP remains the same
(4) Price level decreases; real GDP decreases
ACTIVE LEARNING EXERCISE

This is a brief exercise to help students condense the material on macroeconomic equilibrium into
important concepts that could be test material. Be sure to have students ready to cite the location of
support for their answers in the text.
Divide the class into four groups. Assign each group one of the four components of aggregate demand
(C, I, G, X). Have each group list as many ways as possible that they could increase aggregate demand.
For instance, the group representing consumption could lower tax rates. Then have the class as a whole
discuss why some of these methods have more impact than others.
in part.

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Macroeconomics 9th Edition Boyes

Macroeconomic Equilibrium: Aggregate

OVERVIEW AND OBJECTIVES

KEY TERM REVIEW

LECTURE OUTLINE AND TEACHING STRATEGIES

II. Factors That Influence Aggregate Demand

III. The Aggregate Demand Curve

IV. Aggregate Supply

C. Changes in aggregate supply: Nonprice determinants

V. Aggregate Demand and Supply Equilibrium

OPPORTUNITIES FOR DISCUSSION

13. A horizontal AS has the price level fixed:

14. With a vertical AS curve, real GDP is unchanged:

Both equilibrium price level and real GDP fall.

b. Net exports rise so AD rises:

Both equilibrium price level and real GDP rise.

Both equilibrium price level and real GDP fall.

d. Government spending increases so AD rises:

Both equilibrium price level and real GDP rise.

Equilibrium price level rises and equilibrium real GDP falls.

Equilibrium price level falls and equilibrium real GDP rises.

ANSWERS TO STUDY GUIDE HOMEWORK

ACTIVE LEARNING EXERCISE

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