H201 Study Guide 3
Chapter 12 – Aggregate Demand and Aggregate Supply Analysis
1. Explain the Wealth Effect, the Interest Rate Effect, and the International Trade
Wealth Effect: The effect price level has on consumption
P down= W/P up, spending up
The Interest Rate Effect: The effect price level has on investment
P down= M/P up, interest rates down, spending up
The International Trade Effect: The effect price level has on net exports
P down= Exports up, imports down, net exports up, spending up
2. Name the three factors that could shift the AD curve
1. Change in expectations of households and firms
2. Change in price level
3. Change in government policy
3. Define Fiscal and Monetary Policy. Explain how Fiscal Policy and Monetary
Policy could be used to shift the AD curve to the left or the right.
Fiscal Policy: The changes in federal taxes and spending that are meant to attain
macroeconomic policy objectives. Ad shifts right is government spending is up
and taxes are down
Monetary policy: the actions the federal reserve takes to monitor the money
supply and interest rates in order to pursue macroeconomic policy objectives
M up, M/P up, interest rates down, spending up
4. How do changes in expectations affect the AD curve?
If people are more optimistic about their future incomes, instead of just waiting
around they are willing to increase their consumption now instead of later.
5. How do changes in Foreign Variables such as exchange rates or the
income level in foreign countries affect the AD curve
The higher the income level in foreign countries, the better it is for our exports
If money depreciates in comparison to foreign currencies, exchange rates may
change if money is worth less it is also good for our exports
6. What are four reasons which explain the upward sloping Short Run
Aggregate Supply Curve?
1. Contracts make some prices and wages sticky 2. Firms are often slow to adjust wages
3. Menu costs make some prices sticky
4. Shortages and bottlenecks occur as economy approaches Yfe
7. Explain the Profit Effect and the Cost Effect
Profit effect: When price level goes revenue increases faster than cost
Cost effect: As economy approaches full employment level, shortages and
bottlenecks occur which makes the slop of the short run aggregate supply curve
is increasingly steep
8. How do the Profit Effect and the Cost Effect affect the slope of the Short
Run Aggregate Supply Curve?
Profit makes graph go up and cost makes it steep
Some prices and wages are slow to adjust so price will increase faster
9. Name five factors that shift the Short Run AS curve
1. Size of labor force and capital stock
2. Expectations of future price level
3. Adjustments to workers and firms due to errors in past expectations of price
5. Unexpected increase in price of important resource
10. Draw the AD-AS graph and indicate a Supply Shock – graphically and in
words explain what will happen.
Supply shock is when graph shift left or right due to an unexpected event
11.What is meant by “Validating Inflation”? Explain and draw the graph.
Validating inflation is when economy is self correcting too slowly, so we shift Ad
curve to speed it up by accepting a permanently higher price level and using
monetary or fiscal policy
12. What will happen if the AD curve shifts to intersect Short Run AS to the right
of the full employment level of Y? Explain and draw the graph
Wages will adjust so that AD curves shifts to intersect AS curve at Yfe
13. Why do we draw the Long Run Aggregate Supply Curve as a vertical line?
In the long run, it is AS if LRAS is vertical at Yfe
14. Name three factors that determine the long run level of real GDP.
1. Size of labor force
3. size of capital stock 15. Does rising productivity growth reduce employment in the long run?
No. People are against increasing productivity because they lose their jobs in the
short run, but as wealth increases, new industries are created
Chapter 11 – Output and Consumption in the Short Run
1. Why did the Classical School believe that the economy would always
move to Yfe in the long run?
They believe that the short run will always self correct so that AS
intersects with AD at Yfe
2. What was the point that John Maynard Keynes was trying to make when he
said, “in the long run we are all dead”?
That the classical school wasn’t specific about how long the long run was. He
though that it was important to know because markets take a very long time to
3.What are the three leakages that must equal injections if the economy is to be
Savings+ total taxes+ imports = leakages
4. What is Say’s Law?
Say’s law is that supply creates its own demand. In the time it take to produce
something, people will have earned enough money to afford it.
5. Keynes said that in order to have equilibrium, it is necessary that
planned_____ _______ spending equals income.
6. Define endogenous, exogenous, and autonomous
Endo- determined within model
Exo- determined outside of model
Auto- constant within model
7. Leaving out Government spending and net exports, it is always true that
savings equals _______investments______?
8. In the graph of the Keynesian model, what is the significance of the 45 degree
line? The 45 degree line is the AS curve and equilibrium curve
price level is exogenous
9. What are the 7 determinants of consumption spending?
1. Price Level
2. Taxes 3. income
4. credit availability
5. interest rates
10. What are the 6 determinants of investment spending?
2. Interest rates
3. Technology and innovation
4. Size of capital stock
6. Cash flow
11. Draw the Investment Demand Curve graph and write the Investment
equation. Define “b” and explain it’s significance. What is the implication of
Change in investment in response to change in interest rates
I=constant I – bi
B is the interest rate sensitivity of investment demand
B=0 so I = constant I no matter what
12. What is the relationship between time since 1979 and real consumption?
Increased pretty steadily
13. What has caused investment spending since 1979 to occasionally decrease?
Occasionally decreases during recessions because people have negative
14. What has been the trend in real government purchases since 1979?
Pretty pronounced increase, flat in 90’s but up overall
15. What happened to net exports between 1994 and 2004?
Decreased by 100-150 bil, then increased, then decreased again in 95 and has
been down since
16. What are 3 determinants of net exports?
1. Level of real GDP compared to GDP of other countries
2. Price level in U.S. compared to other countries
3. exchange rate in U.S. to other countries
17. What is the effect of a lower price level on the Quantity of Aggregate
Q of AD increases
18. What is the “Engine” of the Keynesian model? Inventories
19. What is the difference between inventory investment and planned inventory
Inventory investment: goods not purchased
Planned inventory investment: the more cars you have on a lot, the likelier it is
that someone will buy one
20. Draw the Keynesian diagram and indicate areas of excess and depleted
inventories – explain the movement toward equilibrium.
Movement towards equilibrium where planned spending =’s income
As above AD is excess
AS is below AD is depleted
21. Graph the Consumption Function, write the Consumption equation, and
indicate areas of autonomous and induced consumption
consumption function is c= constant c- cy
22. Define MPC, APC, MPS, and APS
Marginal prosperity to consume: change in C/change in Y: slope of consumption
Average prosperity to consume c/y
MPS marginal prosperity to save: change in s/change in Y slope of savings curve
Average prosperity to save s/y
23. On the same graph, graph the consumption function and the implied
24. Graph equilibrium in the Keynesian model using the savings equals
25. Define the Paradox of Thrift and illustrate the answer to the paradox
if everyone decides to save their money, overall savings would be less. What is
good for one person is not necessarily good for economy as a whole
26. What is the relationship between the MPC and equilibrium Y?
the higher the MPC the higher the equilib