The Aggregate Supply / Aggregate Demand Model: Conceptual Questions and Solutions

Problem 31. Which of these explain the downward slope of the Aggregate Demand (AD) curve? More than one answer is possible.

(a) International Forces: Domestic goods become relatively cheaper with respect to foreign goods when domestic prices decline.
(b) Debtors become richer than they were expecting to as a result of the drop in prices.
(c) As prices increase, creditors become richer.
(d) The Multiplier Effect: Government spending increases total output in the economy by more than the amount of the spending.
(e) The Wealth Effect: Consumers' purchasing power increases as prices decline.
(f) The Inflation Tax: As prices increase, the cost of holding onto cash increases.
(g) There is a negative relationship between prices and output. As prices decline, output increases.

Solution 31. The three factors which explain the downward slope of the Aggregate Demand (AD) curve are
(a): International Forces: Domestic goods become relatively cheaper with respect to foreign goods when domestic prices decline.
(e): The Wealth Effect: Consumers' purchasing power increases as prices decline.
(g): There is a negative relationship between prices and output. As prices decline, output increases.

Problem 32. Which of these macroeconomic models allows one to conclude that expansionary monetary policy can be inflationary?

(a) The Random Walk model
(b) The Simple Keynesian model
(c) The IS-LM model
(d) The Aggregate Supply-Aggregate Demand (AS-AD) model
(e) The Theory of Just Price
(f) The Black-Scholes model

Solution 32. Of these, only the AS-AD model allows one to explicitly view price as a variable directly affected by expansionary monetary policy. An increase in government spending G affects Y (output), i (interest rates), and P (price level). In the IS-LM and Simple Keynesian model, P is fixed, so inflation is not accounted for. The Random Walk model has nothing to say about causality, and the Theory of Just Price is simply normative. The Black-Scholes model deals with pricing options, not macroeconomic policies. Thus, (d) is the correct answer.

Problem 33. Which of these statements about the Aggregate Supply (AS) curve are true? More than one answer is possible.

(a) A horizontal AS curve assumes complete wage and price stickiness.
(b) The pure Keynesian case holds that AS is horizontal.
(c) The pure Keynesian case holds that AS is vertical.
(d) The pure Classical case holds that AS is vertical.
(e) The pure Classical case holds that AS is horizontal.
(f) AS can shift out as a result of changes in technology and improvements in the institutional environment.
(g) A horizontal AS curve is consistent with the view that an expansionary monetary policy is purely inflationary.
(h) The AS curve can slope diagonally upward to account for a combination of intermediate-run factors that render output somewhat responsive changes in aggregate demand, but not entirely so.

Solution 33. The correct answers are

(a): A horizontal AS curve assumes complete wage and price stickiness.
(b): The pure Keynesian case holds that AS is horizontal.
(d): The pure Classical case holds that AS is vertical.
(f): AS can shift out as a result of changes in technology and improvements in the institutional environment.
(h): The AS curve can slope diagonally upward to account for a combination of intermediate-run factors that render output somewhat responsive to changes in aggregate demand, but not entirely so.

Problem 34. Which of these are characteristics of the Random Walk model? More than one answer is possible.

(a) There is significant wage and price stickiness.
(b) Surprises are virtually always small and do not account for substantial deviations from prior data.
(c) Information is very quickly incorporated into prices and economic actors' decisions.
(d) There is a steady, predictable long-run growth trend in output.
(e) It is impossible to say with any degree of confidence what the output, prices, and inflation next time period will be.
(f) All unemployment is voluntary.

Solution 34. The only correct answer is

(c): Information is very quickly incorporated into prices and economic actors' decisions.

The Random Walk model rejects assumptions (a) and (d), has little or nothing to say about (f), and recognizes that, while large surprises are possible ((b) is false), it is also the case that present returns are highly correlated with past returns ((e) is false), so some confidence in the future may be warranted.

Problem 35. What is true about the short run in the AS-AD model? More than one answer is possible.

(a) The short-run AS curve is vertical.
(b) Aggregate demand shifts largely affect output in the short run.
(c) The concept of scarcity is crucially important in the short run.
(d) It is possible for government expansionary monetary policy to boost output in the short run.
(e) Technological progress is so rapid that it is the dominant cause of changes in output.

Solution 35. The correct answers are

(b): Aggregate demand shifts largely affect output in the short run.
(d): It is possible for government expansionary monetary policy to boost output in the short run.

See Mr. Stolyarov's complete index of Intermediate Macroeconomics Problems and Solutions here.