Tutorial 10
Chapter 13: Aggregate demand and aggregate supply
Multiple choice questions
Question 1
In a closed economy, which of the following factors would NOT shift the AD curve?
a. The central bank’s target inflation rate ( π ).
Feedback: Incorrect. Any exogenous variable that shifts the TR curve also shifts the
AD curve.
Page reference: 331
*b. The price level.
Feedback: Correct. Because the inflation rate is endogenous, so too must be the price
level.
Page reference: 331
c. The central bank’s natural rate of interest ( i ).
Feedback: Incorrect. Any exogenous variable that shifts the TR curve also shifts the
AD curve.
Page reference: 331
d. The inflation expectation (πe ) in Fisher equation.
Feedback: Incorrect. Inflation expectation shifts the real rate of interest, and thus
shifts AD curve.
Page reference: 327
Question 2
For a closed economy that begins in period 0 at the long-run equilibrium point A, a
monetary policy expansion from a change in the target inflation rate in the Taylor rule
shifts aggregate demand from AD to AD´. The new long-run equilibrium for this
economy will be at which of the following points?
Feedback: In the long run, the economy will settle at point C, with GDP equal to
trend output and the increase in inflation equal to the increase in the target inflation
rate. Short-run equilibrium occurs at point B, where actual inflation exceeds
underlying inflation. Thereafter, underlying inflation increases to its long-run level
and the economy moves from point B towards point C. See Figure 13.13.
Page reference: 332
Correct answer is C.
Question 3
For a closed economy that begins in a long-run equilibrium at point A, there is an
adverse supply shock that shifts the short-run aggregate supply curve from AS to AS´.
If wage negotiators know that there will be a strong anti-inflation policy response to
the supply shock and its aftermath, then the ultimate path of the economy will look
like a movement from which ONE of the following?
a. A to B to A.
Feedback: Incorrect. See Figure 13.14.
Page reference: 334
*b. A to E to A.
Feedback: Correct. See Figure 13.14. The strong anti-inflation response will move
the AD curve to the left.
Page reference: 334
c. A to D to A.
Feedback: Incorrect. See Figure 13.14. This would be the case if there is no response
by the central bank to the higher inflation.
Page reference: 334
d. A to D to C.
Feedback: Incorrect. See Figure 13.14.
Page reference: 334
Question 4
The output cost of disinflation drops when which ONE of the following is true?
a. The AS curve is flatter.
Feedback: Incorrect. This would require an even larger drop in output to get a drop in
the inflation rate.
Page reference: 339
*b. The AS curve shifts down faster.
Feedback: Correct. AS will shift down faster the more the underlying rate of inflation
is determined by forward-looking factors, e.g., anticipating lower long-run
equilibrium inflation.
Page reference: 339
c. The AD curve is flatter.
Feedback: Incorrect. This matters for how much the policymaker would want to have
the AD curve shift left, but the terms of the trade-off between the drop of lower
inflation for lower output are determined by the AS curve.
Page reference: 339
d. If inflation expectations adjust slowly.
2
Feedback: Incorrect. This means that the AS curve shifts down slowly as well and
output will be below its equilibrium level for a longer time.
Page reference: 339
Question 5
For a closed economy that begins in a long-run equilibrium at point A, there is a ONEPERIOD, positive demand shock that shifts the short-run demand curve from AD to
AD´. Which ONE of the flowing time path captures completely the adjustment of the
economy?
a. A to B to A.
Feedback: Incorrect. In the first period, AD moves to AD’. In the second period, AS
shifts to AS’, because at B the actual inflation is higher than the underlying inflation.
b. A to B to C.
Feedback: Incorrect. In the first period, AD moves to AD’. In the second period, AD
shifts back to the original position AD as the shock disappears. The economy never
reaches point C.
c. A to B to D.
Feedback: Incorrect. In the first period, AD moves to AD’. In the second period, AS
shifts to AS’ and AD shifts back to the original position AD (as the shock disappears).
But D is not the long-run equilibrium of the economy. In the following periods,
aggregate curve shifts gradually back to AS.
*d. A to B to D to A.
Feedback: Correct. See Feedback of c.
Open questions:
Question 1: Use the AD-AS model to trace out the short-term effect, in a closed
economy, of: (1) a one-off increase in government spending; (2) a permanent increase
in the inflation target of the central bank.
Answer:
Question 1: Here we consider only the adjustment in the period immediately
following the shock.
(i) A one-off increase in government spending (without any change in monetary
policy). The increase in government spending shifts AD to the right. The economy
moves from A to B. See also graph on the next page.
(ii) A permanent increase in the inflation target. An increase in the inflation target
leads the central bank to lower the interest rate. The TR curve shifts down and demand
increases. The AD curve shifts to the right. The economy moves from A to B. See also
graph on the next page.
3
Question 2: There are many possible configurations depending on where the LAD
schedule lies. Here is one example, with initial equilibrium at point A and LAD
corresponding to the short-run AD schedule. We know that the economy will
eventually move to point C. How? Note that AS is drawn for an underlying inflation
rate corresponding to point B, which exceeds the actual rate. Eventually, the
underlying inflation rate will start declining and the AS curve will shift to the right.
This will go on until it reaches AS’ and the economy will rest at point C.
4
Extra questions: Exercises 6 and 12 from the book. Consider only the case of a
closed economy.
6. Panel (a) below shows the case where supply shocks dominate. They trace out a
portion of the AD schedule, with a negative correlation between output and inflation.
In panel (b), demand shocks trace out a portion of the AS schedule with a
corresponding positive correlation between output and inflation.
The Phillips curve emerges in case (b) because supply is stable and the Phillips curve
is just the mirror image of the AS curve when we look at the unemployment rate
instead of the output gap.
12. For any given shape of the AS curve, the contractionary/expansionary effect (on
prices) will be anticipated and incorporated into expectations. The only point at which
the expectations are correct is when output equals the equilibrium level. This would
lead to immediate declines/increases in nominal wages and prices.
In all cases, the AS curve immediately jumps to its long run position because
underlying inflation, being forward looking, fully anticipates the long run situation.
Thus there is no short run effect or, more precisely, the long run occurs immediately.
5
Chapter 16: Demand management policies
Multiple choice questions
Question 1
‘Macroeconomic policy is plagued by recognition, decision, implementation and
effectiveness lags.’ Neoclassic macroeconomists conclude from this which ONE of
the following?
Page reference: 414–418
a. That governments require better information than other economic actors.
Feedback: Incorrect. No, keeping economic actors in the dark is going to cost the
economy in efficiency terms. This is not a view of neoclassic or Keynesian
macroeconomists.
*b. That aggressive use of macroeconomic policy will work to further destabilize the
economy.
Feedback: Correct. Yes, because one sees the problem too late and hesitates before
doing anything, and so the impact of what one does is like turning a supertanker (it
takes a while).
c. That the macroeconomy is essentially unstable.
Feedback: Incorrect. No, they believe precisely the opposite.
d. That underlying inflation shifts only slowly.
Feedback: Incorrect. No, this is an issue of the relative importance of the length of
nominal contracts and whether expectations are formed rationally, and not one of
policy lags.
Question 2
Assume that the ECB implements an expansionary demand policy in order to increase
employment. If Europe is characterized by Keynesian assumptions with
unemployment in the initial situation, this policy has the following macroeconomic
consequences:
Page reference: 405-406.
a. AD–curve shifts outwards, unemployment increases, aggregate production
increases and the price level increases.
b. AD–curve shifts outwards, unemployment decreases, aggregate production
increases and the price level increases.
c. AD–curve shifts inwards, unemployment decreases, aggregate production increases
and the price level increases.
d. AD–curve shifts outwards, unemployment decreases, aggregate production
increases and the price level decreases.
Feedback: Correct answer is B, see also Figure 16.2.
Open question: Exercise 10 from the book.
10. Note that it should be ‘increase’ instead of ‘adjust’ in the 4th line of the question.
1. Sharp rise in oil prices leads to a one-time leftward shift in the AS curve.
2. If the central bank does not increase its inflation target it can do two things (see
also Figure 16.12):
(1) Wait until the AS curve gradually comes back down (from B to A)
(2) Fight inflation by bringing the AD curve down (from B, C, D to A)
6
In both cases there will be a recession as output falls, the recession will be larger in
the second case.
3. If the central bank wants to avoid this recession, it should undertake measures to
shift the AD curve to right.
4. Counter-argument: When the demand management is pursued using monetary
policy, it may be difficult to convince the public that the inflation target has not been
increased. If underlying inflation rises, then inflation will be difficult to bring down
again.
Extra questions: Exercises 1, 2 (skip the last question), and 3 from the book.
1. In the diagram below, the AD curve has shifted left and the economy is at point B.
Keynesian activist demand policy is based on the simple notion that, while the
economy may correct itself in the long run and return to its equilibrium level of
output, this return may take a very long time if nominal prices and wages do not
decline in an appropriate way. In addition, sharp declines in “animal spirits” can
impede adjustment, as appears to have been the case in the Great Depression. Rather
than “losing” this GDP over many years of slow adjustment, the Keynesian position is
that the government can and should do something about it, moving the AD curve out
again. Expansionary fiscal policy in the form of tax cuts and spending increases, or
monetary policy expressed as reductions in interest rates or open market operations,
are seen as a necessary measure to keep the economy close to its long-run potential.
The neoclassical critique of this policy response has several aspects. First, they argue
that instruments of demand management are not effective. Fiscal policy multipliers
are low or zero for any number of reasons. Ricardian equivalence negates the demand
effect of tax cuts. In general such policies increase the role of the government in the
economy, which is seen to be wasteful and distortionary. The Friedman critique of
activist policy states that even if there are a set of demand policies that could affect
aggregate demand, the implementation of policy is imperfect and characterized by
time lags in the recognition, decision, and implementation of the responses. Policy –
especially monetary policy – therefore is characterized by long and variable lags.
Finally many neoclassical economists maintain that economic downturns are a normal
and even necessary part of the economic picture. Better to simply sit out the storm,
letting AS shift down to AS´ and wait for AD to shift right.
7
2. Underlying inflation represents both the expectations of agents of future inflation as
well as the role of past expectations of inflation for present behaviour, especially
wage and price contracts. Underlying inflation determines the willingness of firms
and workers to provide output that is demanded – it determines the position of the
aggregate supply curve. This can affect the effectiveness of policy in the following
way. Suppose the central bank raises its target rate of inflation in a regime of floating
exchange rates. This implies that the AD shifts out to the right. For a given AS curve
this will raise output (and inflation). If underlying inflation rises quickly in response,
the AS curve also shifts upward, thus negating much or all of the output effects of
intended policy. The effectiveness of policy thus depends on stable underlying
inflation, which implies that inflation is expected to remain stable and not increase.
Economic agents cannot predict the future perfectly but they will certainly try to do
the best they can, given the resources at their disposal. Systematic mistakes are likely
to lead to correction, and to more sensitive underlying inflation.
3. The AS curve measures the readiness of the suppliers of goods and services,
summarized in the behaviour of workers and firms, to supply output. This readiness is
a function of perceived or actual increases in wages and prices. The AS curve is
sloped positively. The slope of the AS curve measures the sensitivity of the price and
wage setting process to deviations of output from its trend or “normal” level. A
steeper AS curve means that inflation will accelerate faster in the aftermath of an
increase in output and fall faster when demand declines. Clearly, the slope of the AS
curve will affect demand policy’s ability to move output in the short run. If the AS is
flat, an expansionary monetary or fiscal policy action is less likely to be dissipated by
an increase in inflation. Similarly, declines in demand are less likely to lead to
protracted recessions (negative deviations from trend output). Empirically, the AS
curve appears flat in most industrial countries, and results from institutions which
have grown up in an environment of low and predictable inflation. A steep AS curve
is usually observed in countries with a long tradition of high and variable inflation,
meaning that cost of living clauses and indexation tend to be the rule and that unions
negotiate annually or more frequently over nominal wage increases.
8