BUSI 101 - Chapter 14

(a)2 Why is the term “business cycle” somewhat misleading?

(a)3 Why is real GDP commonly used to track economic fluctuations even though many other macroeconomic variables could also be used?

(a)4 Why is investment spending especially important in explaining the severity of recessions?

(a)5 Why does unemployment normally rise when real GDP falls?

(a)2 “Cycle” suggests a regular repeating pattern, but recessions do not occur at predictable intervals or with predictable severity.

(a)3 Real GDP is the broadest measure of total production and real income. Because most macroeconomic quantities move together, however, recessions also appear in income, profits, consumption, investment, sales, and production data.

(a)4 Investment is unusually volatile. Firms can quickly postpone factories, equipment, housing projects, and inventory accumulation when expected profitability deteriorates, so relatively modest changes in investment can produce large GDP fluctuations.

(a)5 Producing less output requires less labour. Firms respond to weak sales by reducing production and laying off workers, increasing unemployment.

(b)1 Why can classical macroeconomic theory describe the economy reasonably well in the long run but not necessarily in the short run?

(b)2 What are the classical dichotomy and monetary neutrality, and why must the short-run model relax these assumptions?

(b)3 What two variables does the aggregate-demand/aggregate-supply model place on its axes, and why is their interaction important?

(b)4 What do the aggregate-demand and aggregate-supply curves represent?

(b)5 Why should the aggregate-demand/aggregate-supply model not be interpreted simply as an enlarged version of supply and demand for one individual product?

(b)1 Over long periods wages, prices, and expectations have time to adjust, allowing classical relationships to prevail. In the short run these adjustments are incomplete, so nominal changes can temporarily affect real output and employment.

(b)2 The classical dichotomy separates real and nominal variables, while monetary neutrality says money affects nominal but not real variables in the long run. Short-run fluctuations require relaxing these assumptions because changes in money and prices can temporarily affect output and employment.

(b)3 The vertical axis is the overall price level and the horizontal axis is real GDP. Their interaction shows how nominal conditions and real production jointly determine short-run equilibrium.

(b)4 Aggregate demand shows total goods and services households, firms, governments, and foreign buyers wish to purchase at each price level. Aggregate supply shows the total quantity firms wish to produce and sell at each price level.

(b)5 In a single market, buyers and sellers can substitute resources toward or away from other products. For the entire economy there is no “other market” to substitute into, so macroeconomic explanations are needed for the slopes of AD and AS.

(c)1 Starting from Y=C+I+G+NX, explain why understanding the slope of aggregate demand requires examining consumption, investment, and net exports.

(c)2 Explain the wealth effect that causes a lower price level to increase aggregate demand.

(c)3 Explain the interest-rate effect that causes a lower price level to increase aggregate demand.

(c)4 Explain the real-exchange-rate effect that causes a lower Canadian price level to increase aggregate demand.

(c)5 Combine the wealth, interest-rate, and exchange-rate effects into one causal explanation for why the aggregate-demand curve slopes downward.

(c)1 Aggregate demand consists of C+I+G+NX. With government purchases initially treated as fixed, a change in the price level affects aggregate spending primarily through consumption, investment, and net exports.

(c)2 A lower price level increases the purchasing power of money balances. Households become wealthier in real terms and increase consumption.

(c)3 A lower price level reduces the amount of money needed for transactions. Households attempt to lend excess money, interest rates fall, borrowing becomes cheaper, and investment rises.

(c)4 With the nominal exchange rate initially held constant, a lower Canadian price level reduces Canada’s real exchange rate. Canadian goods become relatively cheaper, exports rise, imports fall, and NX increases.

(c)5 Lower prices raise real wealth and consumption, lower interest rates and stimulate investment, and depreciate the real exchange rate and stimulate net exports. All three raise total quantity demanded.

(d)1 If the overall price level rises while the money supply is unchanged, trace the likely effects on real wealth, interest rates, investment, the real exchange rate, net exports, and aggregate quantity demanded.

(d)2 What is the difference between a movement along the aggregate-demand curve and a shift of the aggregate-demand curve?

(d)3 Why is the aggregate-demand curve drawn holding the money supply and other determinants of spending constant?

(d)4 A stock-market boom makes households feel wealthier. Which curve shifts, in which direction, and why?

(d)5 A major fall in house prices reduces household net worth. How would this most directly affect consumption and aggregate demand?

(d)1 Real money balances fall, consumers feel less wealthy and reduce consumption, money demand pushes interest rates upward and investment falls, Canadian goods become relatively more expensive, the real exchange rate appreciates, NX falls, and total quantity demanded decreases.

(d)2 A change in the price level causes movement along AD. A change in some other determinant of C, I, G, or NX shifts the entire AD curve.

(d)3 The curve isolates the relationship between the price level and quantity demanded. If money or another spending determinant changes simultaneously, the whole relationship changes and AD shifts.

(d)4 AD shifts right because higher wealth raises consumption at every given price level.

(d)5 Lower housing wealth reduces household net worth and tends to reduce consumption, shifting AD left.

(e)1 How can changes in taxes shift aggregate demand through consumption?

(e)2 Why can changes in housing wealth have a particularly important effect on Canadian consumption spending?

(e)3 A new technology makes firms eager to purchase equipment. What happens to investment and aggregate demand?

(e)4 How do an investment tax credit and a short-run increase in the money supply affect aggregate demand through investment?

(e)5 How do changes in government purchases shift aggregate demand, and why is this mechanism more direct than many other aggregate-demand shifts?

(e)1 Lower taxes increase disposable income and consumption, shifting AD right. Higher taxes reduce disposable income and consumption, shifting AD left.

(e)2 Housing is a major component of household wealth and is broadly held across households. Large changes in housing equity can therefore affect the consumption decisions of many families.

(e)3 Investment rises at each price level, so AD shifts right.

(e)4 An investment tax credit directly encourages capital spending. An increase in the money supply lowers short-run interest rates and encourages borrowing and investment. Both shift AD right.

(e)5 Government purchases are themselves a component of aggregate demand. Higher G directly adds to total spending and shifts AD right; lower G shifts it left.

(f)1 A major Canadian trading partner enters a recession. Explain the effect on Canadian net exports and aggregate demand.

(f)2 International investors bid up the Canadian dollar. How does this affect Canadian net exports and aggregate demand?

(f)3 Classify each of the following as shifting AD right or left: increased consumer optimism, higher taxes, increased government purchases, falling foreign income, and a depreciation of the Canadian dollar.

(f)4 Why does a change in the price level itself not shift aggregate demand, whereas a change in consumer confidence does?

(f)5 What general rule can you use to determine whether any event shifts aggregate demand left or right?

(f)1 Foreign income falls, reducing foreign demand for Canadian exports. Canadian NX falls and AD shifts left.

(f)2 Appreciation makes Canadian goods relatively expensive and foreign goods cheaper. Exports fall, imports rise, NX falls, and AD shifts left.

(f)3 Increased optimism: right. Higher taxes: left. Increased government purchases: right. Falling foreign income: left. Canadian-dollar depreciation: right.

(f)4 The price-level change changes quantity demanded through the three slope effects and causes movement along AD. Consumer confidence changes desired spending at every price level, shifting AD.

(f)5 Ask whether the event raises or lowers C, I, G, or NX at a given price level. Higher total planned expenditure shifts AD right; lower expenditure shifts it left.

(g)1 Why is the long-run aggregate-supply curve vertical?

(g)2 What is the natural level of output, and why should it not be interpreted as the maximum output the economy could ever physically produce?

(g)3 How does the vertical LRAS curve represent the classical dichotomy and monetary neutrality?

(g)4 What four broad determinants of productive capacity can shift the long-run aggregate-supply curve?

(g)5 Why does changing the money supply not shift LRAS in the classical long-run model?

(g)1 Long-run output depends on labour, capital, natural resources, and technology rather than the price level. Changing prices alone therefore does not change long-run production.

(g)2 It is the output produced when unemployment is at its natural rate and resources are being used at their normal sustainable levels. It is not an absolute physical maximum.

(g)3 Output is a real variable while the price level is nominal. A vertical LRAS means different price levels can coexist with the same long-run real output.

(g)4 Labour, physical and human capital, natural resources, and technological knowledge.

(g)5 Money changes nominal prices in the long run but does not create additional productive resources or technology.

(h)1 How would increased immigration normally affect LRAS, and through what mechanism?

(h)2 How can a change in the natural rate of unemployment shift LRAS?

(h)3 Why do increases in both physical capital and human capital shift LRAS to the right?

(h)4 Give the general effects on LRAS of discovering new natural resources versus losing access to an important productive resource.

(h)5 Why can technological progress and greater international trade both be represented as rightward shifts of LRAS?

(h)1 More workers increase the economy’s productive capacity, shifting LRAS right.

(h)2 A lower natural unemployment rate means more labour is normally employed and shifts LRAS right. A higher natural rate lowers natural output and shifts LRAS left.

(h)3 Both increase worker productivity and the economy’s sustainable productive capacity.

(h)4 A new productive resource raises capacity and shifts LRAS right. Loss of an important resource reduces capacity and shifts LRAS left.

(h)5 Technology enables more output from existing inputs. Trade can similarly raise productivity through specialization and access to more efficient production possibilities.

(i)1 Over long periods, how can simultaneous rightward shifts in aggregate demand and LRAS explain both economic growth and inflation?

(i)2 If technological progress continues at the same rate but the Bank of Canada slows money growth, what happens to long-run output growth and inflation in the model?

(i)3 Why should short-run fluctuations be viewed as deviations around continuing long-run trends in output and prices?

(i)4 Why is the aggregate-supply curve upward sloping in the short run but vertical in the long run?

(i)5 What common principle links the sticky-wage, sticky-price, and misperceptions explanations of short-run aggregate supply?

(i)1 Technological progress shifts LRAS right, generating rising real output. Money growth shifts AD right. If AD grows faster than productive capacity, the price level rises as well.

(i)2 Trend output growth is unchanged because it depends on real productive factors. Inflation falls because AD grows more slowly relative to LRAS.

(i)3 The economy is normally experiencing underlying growth and inflation even while recessions and booms temporarily push output and prices away from those trends.

(i)4 In the short run, sticky wages, sticky prices, and misperceptions cause production to respond to unexpected price changes. Eventually those imperfections disappear, leaving output determined solely by real productive capacity.

(i)5 Actual output differs from natural output when the actual price level differs from the price level people had expected.

(j)1 Under the sticky-wage theory, why does an actual price level below the expected price level cause firms to reduce employment and production?

(j)2 Suppose workers agreed to fixed nominal wages based on an expected price level of 100, but the actual price level turns out to be 105. According to sticky-wage theory, what happens temporarily to firms’ profitability, employment, and output?

(j)3 Why do long-term contracts, social norms, and fairness considerations contribute to sticky nominal wages?

(j)4 Under sticky-wage theory, why does the effect of an unexpected price-level change eventually disappear?

(j)5 What relationship between actual and expected prices generates the upward slope of SRAS under sticky-wage theory?

(j)1 Firms receive lower prices for output while contractual nominal wages remain fixed. Real labour costs are therefore higher than anticipated, profitability falls, and firms reduce employment and output.

(j)2 Output prices are about 5 percent higher than expected while nominal wages remain fixed. Production becomes temporarily more profitable, so firms hire more workers and increase output above its natural level.

(j)3 These factors prevent wages from being renegotiated instantly whenever economic conditions change.

(j)4 Contracts expire, expectations adjust, and nominal wages are renegotiated to reflect the actual price level.

(j)5 Actual prices above expected prices temporarily raise output; actual prices below expected prices temporarily lower output.

(k)1 How does sticky-price theory explain why an unexpectedly low overall price level can reduce aggregate output?

(k)2 What are menu costs, and why do they matter for short-run aggregate supply?

(k)3 If aggregate demand unexpectedly falls but some firms leave their prices unchanged, why do those firms tend to reduce production and employment?

(k)4 How does misperceptions theory differ from sticky-price theory in explaining the upward slope of SRAS?

(k)5 If the overall price level unexpectedly rises, how can producers mistakenly interpret the change as an increase in their relative price, and how does that affect output?

(k)1 Some firms cannot or do not immediately lower prices because adjusting them is costly. Their prices become too high relative to current conditions, sales fall, and they reduce output.

(k)2 Menu costs are costs of changing prices, such as deciding new prices, changing tags, catalogues, and systems. They cause some firms to leave prices temporarily unchanged.

(k)3 Their goods become relatively expensive compared with firms that adjust prices, so demand for their products falls.

(k)4 Sticky-price theory assumes firms understand conditions but do not adjust prices immediately because adjustment is costly. Misperceptions theory assumes producers temporarily misunderstand whether a price change is economy-wide or specific to their product.

(k)5 They may observe their own selling price rising before recognizing that other prices are also rising. Believing their relative price has increased, they expand production.

(l)1 What is the common conclusion of the sticky-wage, sticky-price, and misperceptions theories when the actual price level exceeds the expected price level?

(l)2 What happens when the actual price level is below the expected price level?

(l)3 Why do these three explanations generate only temporary deviations of output from its natural level?

(l)4 What variables that shift LRAS also shift SRAS?

(l)5 Why does an increase in the expected price level shift SRAS left, while a decrease in the expected price level shifts SRAS right?

(l)1 Firms temporarily produce more than the natural level of output.

(l)2 Firms temporarily produce less than the natural level.

(l)3 Wages eventually adjust, prices are changed, and mistaken perceptions are corrected. Actual and expected prices converge.

(l)4 Labour, capital, natural resources, and technology.

(l)5 Higher expected prices lead workers and firms to set higher wages and other costs, reducing output supplied at each actual price level. Lower expected prices have the opposite effect.

(m)1 Under sticky-wage theory, trace how higher expected prices affect nominal wages, firms’ costs, and SRAS.

(m)2 How does adjustment of expected prices help move the economy from short-run equilibrium back toward long-run equilibrium?

(m)3 What conditions hold when the economy is in long-run equilibrium in the AD–AS model?

(m)4 What four-step procedure should you use when analyzing an economic shock with the AD–AS model?

(m)5 Why is it important to distinguish the initial short-run response from the eventual long-run response to a shock?

(m)1 Higher expected prices lead workers to negotiate higher nominal wages. Higher labour costs reduce profitability at any given actual price level and shift SRAS left.

(m)2 If actual prices differ from expectations, people revise expected prices. That changes wages, posted prices, and perceptions, shifting SRAS until output returns toward its natural level.

(m)3 AD, SRAS, and LRAS intersect at the same output. Output equals its natural level, and expected prices have adjusted to the actual price level.

(m)4 Identify which curve is affected; determine the direction of the shift; find the new short-run equilibrium; then determine how expectations and curves adjust toward a new long-run equilibrium.

(m)5 Output and employment can change substantially before wages, prices, and expectations adjust. The long-run effect can therefore be very different from the initial effect.

(n)1 Suppose households and firms suddenly become pessimistic about the future. Which curve shifts, in what direction, and what happens to output and the price level in the short run?

(n)2 Why does a contraction in aggregate demand typically cause both recession and rising unemployment?

(n)3 After aggregate demand falls and the actual price level drops below what people expected, what happens to expected prices and SRAS over time?

(n)4 If policymakers do nothing after a temporary leftward shift of aggregate demand, what happens to output and the price level in the long run?

(n)5 Why does the long-run adjustment to a demand shock illustrate monetary neutrality?

(n)1 AD shifts left. In the short run, both real output and the price level fall.

(n)2 Lower planned spending reduces sales. Firms cut production and employment, creating recession and higher unemployment.

(n)3 Expected prices gradually fall. Lower expected wages and costs shift SRAS right.

(n)4 Output eventually returns to its natural level, while the price level settles permanently below its original level.

(n)5 The demand change has a temporary real effect but ultimately changes only a nominal variable—the price level—once adjustment is complete.

(o)1 How could expansionary monetary or fiscal policy reduce the short-run effects of a fall in aggregate demand?

(o)2 What are the three main lessons the chapter draws from shifts in aggregate demand?

(o)3 Why can pessimistic expectations about the economy become partly self-fulfilling in the short run?

(o)4 A contraction in the money supply shifts AD left. Compare its short-run effect on output with its long-run effect on output.

(o)5 Explain the meaning of the statement that “money is a veil, but when the veil flutters, real output sputters.”

(o)1 Increasing the money supply, cutting taxes, or increasing government purchases can shift AD right and partially or fully offset the original leftward shift.

(o)2 Demand shifts change output in the short run; in the long run they affect the price level rather than natural output; and stabilization policy can potentially reduce short-run fluctuations.

(o)3 Pessimism reduces consumption and investment, which reduces actual output and employment, making the anticipated weak economy partly come true.

(o)4 In the short run, output falls. In the long run, expectations and SRAS adjust and output returns to its natural level, while the price level remains lower.

(o)5 Money is neutral in the long run, but during the period in which wages, prices, and expectations are adjusting, monetary disturbances can temporarily change real output and employment.

(p)1 What major types of forces contributed to the collapse in Canadian aggregate demand during the Great Depression according to the chapter?

(p)2 Why would a collapse in stock prices reduce aggregate demand through more than one channel?

(p)3 Why did the absence of a Canadian central bank make a monetary contraction potentially more damaging during the Great Depression?

(p)4 Why did World War II generate a large rightward shift in Canadian aggregate demand?

(p)5 What broad historical comparison supports the idea that monetary and fiscal stabilization policy may reduce the severity of recessions?

(p)1 The chapter emphasizes contraction of the money supply, falling net exports as the U.S. economy weakened, collapsing stock-market wealth, and reduced investment.

(p)2 It reduces household wealth and therefore consumption, while also making it harder for firms to finance investment projects.

(p)3 There was no central bank able to offset the contraction in money creation with expansionary monetary operations.

(p)4 Wartime government purchases increased dramatically, directly shifting AD far to the right and increasing production and employment.

(p)5 The Great Depression involved severe demand collapse with limited policy response, whereas 2008–09 saw faster and stronger monetary and fiscal intervention and a much shallower downturn.

(q)1 How did the 2008–09 financial crisis shift Canadian aggregate demand through both investment and net exports?

(q)2 Why can disruption of the financial system reduce aggregate demand even if consumers themselves have not initially changed their preferences?

(q)3 How did Canadian monetary and fiscal policy attempt to counter the 2008–09 contraction?

(q)4 Why does the comparison between the Great Depression and the 2008–09 recession suggest that the condition of the financial system matters for the transmission of monetary policy?

(q)5 What policy lesson about financial stability does the chapter draw from the 2008–09 crisis?

(q)1 The financial crisis made borrowing difficult and reduced investment, while the U.S. recession sharply reduced demand for Canadian exports. Both shifted Canadian AD left.

(q)2 A frozen credit system prevents firms from financing investment and even ordinary operations, reducing spending and production throughout the economy.

(q)3 The Bank of Canada increased financial-system liquidity, while governments increased spending and introduced tax incentives intended to stimulate private spending.

(q)4 Monetary policy works partly through financial institutions and credit markets. If those markets are impaired, normal interest-rate changes may not translate effectively into borrowing and spending.

(q)5 Macroeconomic stabilization requires attention to financial-system stability because financial disruptions can amplify shocks and interfere with monetary-policy transmission.

(r)1 Suppose production costs suddenly rise while aggregate demand is unchanged. Which curve shifts, in what direction, and what happens to output and the price level in the short run?

(r)2 What is stagflation, and why can an adverse supply shock produce it?

(r)3 Why is stagflation especially difficult for policymakers compared with a simple contraction in aggregate demand?

(r)4 How can an adverse supply shock initially create a wage–price spiral?

(r)5 If policymakers do nothing and the adverse supply shock is temporary, how can the economy eventually return toward its original long-run equilibrium?

(r)1 SRAS shifts left. Short-run output falls and the price level rises.

(r)2 Stagflation is simultaneous stagnation or recession and inflation. An adverse supply shock reduces productive profitability while raising production costs, producing lower output and higher prices.

(r)3 A demand expansion could restore output but worsen inflation, while policies that suppress inflation may leave output and employment depressed.

(r)4 Higher prices may cause workers to expect continuing inflation and demand higher nominal wages. Higher wages raise firms’ costs further, shifting SRAS farther left and causing still higher prices.

(r)5 Weak output and high unemployment reduce workers’ bargaining power. Nominal wages and expectations eventually adjust downward, shifting SRAS back right toward the original equilibrium.

(s)1 What does it mean for policymakers to “accommodate” an adverse shift in aggregate supply?

(s)2 If policymakers respond to a leftward SRAS shift by increasing aggregate demand enough to keep output at its natural level, what happens to the price level?

(s)3 What tradeoff do policymakers face when deciding whether to accommodate an adverse supply shock?

(s)4 Compare the short-run effects of a negative aggregate-demand shock with those of a negative aggregate-supply shock on output and the price level.

(s)5 If real GDP is falling while the price level is also falling, which type of shock is more consistent with the evidence? What if real GDP is falling while the price level is rising?

(s)1 Policymakers increase aggregate demand to offset the loss of output caused by the adverse SRAS shift.

(s)2 Output can remain at its natural level, but the price level rises even further.

(s)3 They can tolerate temporarily lower output and unemployment while allowing prices eventually to adjust, or support output through higher AD at the cost of greater inflation.

(s)4 Both lower output. A negative AD shock lowers the price level, whereas a negative AS shock raises it.

(s)5 Falling GDP plus falling prices is consistent with a negative demand shock. Falling GDP plus rising prices is consistent with an adverse supply shock.

(t)1 Why does an increase in the world price of oil usually shift Canadian SRAS left for firms that use oil as an input?

(t)2 Why can the same increase in oil prices simultaneously increase aggregate demand in major Canadian oil-producing regions?

(t)3 Why can an oil-price increase therefore affect Alberta differently from an oil-importing or manufacturing-intensive province?

(t)4 What happens to aggregate supply when world oil prices fall substantially, other things equal?

(t)5 Why has Canada’s aggregate economy become less sensitive to oil-price shocks over time?

(t)1 Oil is an important input. Higher oil prices increase production costs, reducing the quantity firms are willing to produce at each price level.

(t)2 Higher oil prices increase revenues, incomes, investment, and exports in oil-producing regions, which can increase spending and AD there.

(t)3 Oil producers benefit from higher revenues while manufacturers and consumers face higher costs. The relative strength of these effects differs by province.

(t)4 Production costs fall, SRAS shifts right, output rises, and the price level faces downward pressure.

(t)5 Technology and conservation have reduced the amount of oil required to produce each dollar of real GDP, making oil a smaller component of overall production costs.

(u)1 Why is it incorrect to say that higher oil prices are simply “good” or “bad” for the entire Canadian economy?

(u)2 How can technology that reduces oil required per dollar of real GDP change the macroeconomic effects of an oil-price shock?

(u)3 A new technology sharply lowers production costs across many industries. Predict the short-run effects on output and the price level and the likely effect on LRAS.

(u)4 A new regulation permanently makes several production methods unavailable. Which aggregate-supply curves are likely to shift, and in which direction?

(u)5 What is the chapter’s overall framework for distinguishing between the causes and consequences of demand-side versus supply-side recessions?

(u)1 High prices benefit oil producers and regions dependent on oil production but hurt consumers and firms that use oil. Low prices reverse many of those effects.

(u)2 Lower oil intensity means a given percentage increase in oil prices raises economy-wide production costs by less, producing a smaller adverse supply shock.

(u)3 SRAS shifts right, raising output and lowering the price level in the short run. If the technology permanently increases productivity, LRAS also shifts right.

(u)4 Both SRAS and LRAS are likely to shift left because productive capacity and currently profitable production are reduced.

(u)5 First determine whether the shock changes planned expenditure or production conditions. Demand shocks move output and the price level in the same direction in the short run; supply shocks move output and the price level in opposite directions. Then analyze how expectations and policy determine the transition back toward long-run equilibrium.