Chapter 8: Real GDP and the Price Level in the Short Run

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Answers to Even-Numbered Study Exercises

Fill-in-the-Blank Questions
Question 2
a) aggregate supply (AS)
b) factor prices; technology
c) increases
d) excess capacity; unit costs
e) capacity; unit costs
f) factor prices; technology; shocks

Review Questions
Question 4

a) The holder of cash experiences a reduction in wealth as a result of an increase in the price level,
because the purchasing power of a given amount of cash is reduced. The private sector’s wealth
therefore declines, which reduces desired consumption (at any income level) and thus shifts the
AE function downward.

b) Deposits held in a bank account are assets for the depositors but a liability for the banks. An
increase in the price level reduces the real value of these deposits. The depositor’s wealth is
decreased but that of the bank (or its owners) is increased. Private sector wealth is unchanged, and
the AE function is unaffected.

c) A mortgage is a loan from a financial institution to a homeowner where the value of the home
is used as collateral for the loan. A rise in the price level means that the homeowner makes
payments of reduced real value, and the financial institution receives payments of reduced real
value. The homeowner is wealthier, but the owners of the financial institution are less wealthy.
The wealth of the private sector is unchanged, and so the AE function is unaffected.

d) The holder of the corporate bond has loaned money to the corporation. The rise in the price
level means that the loan repayment (principal and interest) is reduced in real value. The holder of
the bond is therefore made less wealthy. The issuer of the bond (the corporation or its owners) is
made wealthier. The overall wealth of the private sector is unchanged, and hence the AE function
is unaffected.

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 Chapter 8: Real GDP and the Price Level in the Short Run 33

e) The holder of the government bond has loaned money to the government. The rise in the price
level means that the loan repayment (principal and interest) is reduced in real value. The holder of
the bond is therefore made less wealthy, at least this is the direct effect. The issuer of the bond (the
government) is made wealthier. The direct effect is therefore to reduce the overall wealth of the
private sector, and so the AE function shifts downward.

(Note: There is also an indirect effect. Government debt must eventually be repaid through future
taxes. But the increase in the price level that reduces the real value of the government’s outstanding
debt means that taxpayers will have to pay fewer taxes in the future compared to what they would
have had to pay if the price level had remained constant. Thus, the direct effect to reduce
bondholders’ wealth is offset by an indirect effect that raises future taxpayers’ wealth. The net
effect of the change in the price level depends crucially on whether the private sector recognizes
these future tax liabilities, and on whether today’s bondholders are also future taxpayers. Most
empirical evidence suggests that individuals do not fully recognize these changes in future tax
liabilities associated with changes in the government debt. Thus, the increase in the price level
leads to a reduction in the wealth of today’s holders of government bonds.)

Question 6
a) An increase in the minimum wage increases costs for the many firms whose workers earn wages
at this level. This is a negative AS shock, shifting the AS curve upward and to the left.

b) An increase in productivity, with wages held constant, causes a reduction in unit labour costs
for firms. This is a positive AS shock, shifting the AS curve downward and to the right.

c) An increase in demand for Canada’s exports is a positive AD shock, shifting the AD curve to
the right. This causes a movement along the AS curve, upward and to the right.

d) Advances in AI that reduce costs in all service industries are a positive AS shock, shifting the
AS curve downward and to the right.

e) The decline in firms’ desired investment is a negative AD shock, shifting the AD curve to the
left. This causes a movement along the AS curve, downward and to the left.

Question 8
a) A horizontal AS curve reflects the fact that firms are prepared to supply any amount of output
that is demanded of them without requiring an increase in prices. There are two situations that
might lead to this “passive” supply response. The first is when the economy has many unemployed
resources, both labour and capital. In this case, firms have excess capacity and they can increase
output easily without driving up unit costs. The second situation is where firms are price setters—
that is, they have market power in the markets in which they sell their products. Price-setting firms
often respond to changes in demand by initially changing their level of output, and only later
adjusting their prices.

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34 Student Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

b) An upward sloping AS curve reflects the fact that firms are only prepared to supply more output
if prices rise. This is expected in situations where firms can only increase their output by using
their existing resources, especially capital, more intensively. The “law” of eventually diminishing
returns to the variable factor (usually labour) means that increases in output may only be possible
by driving up unit production costs, thus requiring a rise in prices.
c) Output is said to be demand determined in Economy A, the one with the horizontal AS curve.
In this economy, the AD curve alone determines the level of equilibrium GDP.
d) An increase in autonomous expenditure, ∆Α, leads to a rightward shift of the AD curve. The
distance of the shift is exactly equal to the change in autonomous expenditure times the simple
multiplier, z. This is true in both economies. In Economy A, the AS curve is horizontal and so
equilibrium GDP changes by the full amount of the AD shift. In Economy B, however, the change
in equilibrium GDP is less than the full shift because the price level rises. As the price level rises,
desired aggregate expenditure is choked off—this is a movement upward and along the new AD
curve. Thus, Economy A, the one with demand-determined output, has a larger multiplier than
Economy B.

Problems
Question 10
a) See the diagram below.

b) The macroeconomic equilibrium is where the AD and AS curves intersect. The equilibrium price
level is 110; the equilibrium level of real GDP is $900 billion.

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 Chapter 8: Real GDP and the Price Level in the Short Run 35

c) At a price level of 100, firms are prepared to supply an amount of output equal to $825 billion.
The level of desired expenditure is $1000 billion. So there is excess demand in this situation, and
the price level will increase (bringing forth more supply and choking back the level of demand).
d) At a price level of 120, firms are prepared to supply output of $975 billion, but total desired
expenditure is only $800 billion. There is excess supply, which will tend to push the price level
down (encouraging demand and choking back supply).
e) Suppose real GDP equals $900 billion while potential GDP is $950 billion. Recalling the terms
introduced in Chapter 4, this situation is referred to a recessionary output gap.

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