Wealth, interest rate, and exchange rate effects.

1 Aggregate Demand

4. Explain the intuition behind the wealth, interest rate, and exchange rate effects.

The intuition behind the real wealth effect is that when the price level decreases, it takes less

money to buy goods and services. The money you have is now worth more and you feel

wealthier. So, in response to a decrease in the price level, real GDP will increase. More

formally, this means that when households assets are worth more in terms of their

purchasing power, they are more likely to purchase more goods and services.

The opposite happens when the price level increases. If the price of everything increases, but

the number of dollars you have doesnt, then you have to cut back on spending. Some

shorthand of this chain of events can help us wrap our heads around this:

PLreal wealth consumption increasesmove right along AD curve

The intuition behind the interest rate effect is that when the price level decreases, you need

less money in your pocket to buy stuff. The less money you need to keep on hand to buy

stuff, the more money you are going to keep in a bank. Banks pay interest to try to lure

people to deposit their money in banks. So, if you are going to keep more money in the bank

anyway, banks dont have to offer as much interest in order to convince you; that drives

interest rates down. As a result, businesses and households spend more money on investment

and big ticket items that are interest sensitive, like X, Y, and Z. So, once again, a decrease

in the price level will increase real GDP.

On the other hand, a higher price level will drive up interest rates. Remember how a higher

price level would make everyones dollars are worth less, and they cut back on consumption?

Well, what if they didnt want to cut back on consumption. Instead, maybe they sell off some

other asset like a bond to try to get more money. The problem is, every other bondholder is

also trying to sell off their bonds, so there are no buyers! Anyone who wants to issue a new

bond is going to have to do something to try to attract buyers. The way to do that is to raise

the interest rate that is offered. All of that excess demand for money leads to an increase in

the interest rate.

Finally, the intuition behind the exchange rate effect is that a decrease in the price level in

country A makes its goods cheaper to country B, so country B buys more of country As

exports. When the price level in one country goes down, its goods are suddenly more

attractive to every other country. Its like the whole country is on sale! Since that countrys

goods are suddenly cheaper, their exports go up.


2 Multipliers

4. Households in Iron Island save 10% of every additional dollar in income that they

receive. What will happen to aggregate demand Maggietopia if there is a $4 billion

increase in lump-sum taxes?

Note: Please answer this question on your own.

3 Short-run Aggregate Supply (SRAS)

2. Describe why there is a short-run relationship between the unemployment rate and

ination. Can you think of a reason why this might not hold up in the long run?


When there is an increase in the price level (inflation), the workers that firms can hire at their

old, stuck wages are relatively cheaper than they used to be. Since labor is now cheaper,

firms are willing to hire more workers, driving down the unemployment rate. Therefore, there

is a short-run negative relationship between inflation and unemployment.



However, it would be surprising if workers are permanently willing to take the same pay if

prices all around them are going up. When there is inflation, real wages are decreasing. We

should expect the workers to get pretty insistent about unsticking those stuck wages



3. What causes SRAS to shift? [Explain]

When the price level changes and firms produce more in response to that, we move along the

SRAS curve. But, any change that makes production different at every possible price level

will shift the SRAS curve. Events like these are called shocks because they arent


For example, imagine the price of labor unexpectedly gets more expensive. In response to

that shock, the SRAS curve decreases (shifts to the left). Interestingly, this happens if firms

expect that this will happen too. If you see it coming, you adjust your expectations

accordingly! If factors of production get cheaper, or producers think they will get cheaper,

then SRAS increases.

You can easily remember all of the shocks that shift SRAS by thinking of SPITE:

Subsidies for businesses


Input prices

Taxes on businesses

Expectations about inflation


4. Why is SRAS curve upward sloping? [Explain]

The SRAS curve slopes up for two reasons: sticky input prices (like wages) and sticky output

prices (also called menu costs)


5. Describe sticky wage theory to someone who has never heard of it before. How would

you describe it?

(also called nominal price rigidity) the idea that some prices and wages are not fully flexible

and cannot completely respond to changes such as inflation or deflation


4 Long-run Aggregate Supply (LRAS)

1. What are the reasons that the aggregate supply curve is vertical in the long-run but

not in the short-run?

The LRAS is vertical because, in the long-run, the potential output an economy can produce

isnt related to the price level. There are only two things that matter for potential output: 1)

the quantity and the quality of a countrys resources, and 2) how it can combine those

resources to produce aggregate output. When an economy is producing exactly its full

employment output, the rate of unemployment is equal to the natural rate of unemployment.

The LRAS curve is also vertical at the full-employment level of output because this is the

amount that would be produced once prices are fully able to adjust. In the short-run, some

prices are sticky. This means that producers might respond to changes in the price level by

changing their output. However, in the long-run, those prices get unstuck, and once they

have fully adjusted the economy will produce the efficient, full employment output.


2. If an economy is producing its potential output, is the current rate of unemployment

less than, greater than, or equal to the natural rate of unemployment? Explain.

If an economy is producing its potential output, the current rate of unemployment would be

equal to the natural rate of unemployment. Potential output is how much would be produced



if all resources, including labor, are used efficiently. If labor is being used efficiently, there is

no excess unemployment or over employment.



5 Equilibrium in the AD-AS model

1. What is the difference between a short-run equilibrium and a long-run equilibrium?

The short-run equilibrium is the point where SRAS and AD intersect, which yields Y_1Y1Y,

start subscript, 1, end subscript as the current output and PL_1PL1P, L, start subscript, 1, end

subscript as the current price level. Notice that Y_1Y1Y, start subscript, 1, end subscript is

more than Y_fYfY, start subscript, f, end subscript, which means that the economy is

producing more than full employment output and has an inflationary gap (another way of

saying this would be that the economy is experiencing a positive output gap).

The short-run equilibrium is the point where SRAS and AD intersect, which yields Y_1Y1Y,

start subscript, 1, end subscript as the current output and PL_1PL1P, L, start subscript, 1, end

subscript as the current price level. Notice two things about this. First, Y_1Y1Y, start

subscript, 1, end subscript is equal to Y_fYfY, start subscript, f, end subscript, which means

that the economy is producing exactly its full employment output and is in long-run

equilibrium. Second, LRAS is always vertical at this point, so the long-run equilibrium is

where all three of these curves intersect.

Thats really the way to think about a long-run equilibriumits really two equilibrium. The

short-run equilibrium (where AD is equal to SRAS) is what the country is currently

producing (Y_1Y1Y, start subscript, 1, end subscript). The definition of the long-run in

economics is long enough for all prices to adjust. When all prices have adjusted, the short-run

output will also be the full employment output.








The answer is in the link above, please find it and paraphrase it. It is the same above answer

but I include the link for your reference because here the mathematical notations are not clear

as on the website.

2. Assume the economy of Johnsrudia is currently operating at short-run equilibrium

and producing $300 million in real GDP and a CPI of 190. However, the full

employment rate of output in Johnsrudia is $350 million. Draw a correctly labeled

graph of the AD-AS model that reflects this information.

If the economy of Maxistan is experiencing the following condition:UR>UR_NUR>URNU,

R, is greater than, U, R, start subscript, N, end subscript then Maxistan is experiencing a

negative output gap and is producing less than its full employment output. This means that

when we are drawing our AD-AS model, we need to make sure that the LRAS curve is to

the right of the current output, as shown in Figure X.



When an economy is producing less than full employment output, it is operating at a

point inside the PPC, as shown in Figure X.


6 Changes in the AD-AS model in the short run

6.1 Shifts in Aggregate Demand


1. How would a dramatic increase in the value of the stock market shift the AD curve?

What effect would the shift have on the equilibrium level of GDP and the price level?

An increase in the value of the stock market would make individuals feel wealthier and thus

more confident about their economic situation. This would likely cause an increase in

consumer confidence leading to an increase in consumer spending, shifting the AD curve to

the right. The result would be an increase in the equilibrium level of GDP and an increase in

the price level.


2. Suppose Mexico, one of our largest trading partners and purchaser of a large

quantity of our exports, goes into a recession. Use the AD/AS model to determine the

likely impact on our equilibrium GDP and price level.

Since imports depend on GDP, if Mexico goes into recession, its GDP declines and so do its

imports. This decline in our exports can be shown as a leftward shift in AD, leading to a

decrease in our GDP and price level.


3. A policymaker claims that tax cuts led the economy out of a recession. Can we use

the AD/AS diagram to show this?

Tax cuts increase consumer and investment spending, depending on where the tax cuts are

targeted. This would shift AD to the right. If the tax cuts occurred when the economy was in

recessionand GDP was less than potentialthe tax cuts would increase GDP and lead the

economy out of recession.




4. Many financial analysts and economists eagerly await reports on the home price

index and consumer confidence index. What would be the effects of negative reports on

both of these? What about positive reports?

A negative report on home prices would make consumers feel like the value of their homes

which for most Americans is a major portion of their wealthhas declined. A negative report

on consumer confidence would make consumers feel pessimistic about the future. Both of

these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the

price level.

A positive report on the home price index or consumer confidence would do the opposite.


5. Name some factors that could cause AD to shift, and explain whether they would shift

AD to the right or to the left.

If we consider that: real GDP = C + I + G + NX (consumption + investment + government

spending + net exports)

Factors causing AD to shift to the right:

– Tax cuts: making consumers more confident –> C rises and so does real GDP

– Tax benefits for companies investing –> I rises and so does real GDP

– Spending on new road infrastructures –> G rises and so does real GDP

– New trade agreement with a new partner –> NX rise and so does real GDP

Factors causing AD to shift to the left:

– Austerity policy by the government –> reduces G and real GDP

– Having a trade partner going into recession –> NX decrease and so does real GDP


6. Would a shift of AD to the right tend to make the equilibrium quantity and price

level higher or lower? What about a shift of AD to the left?

If the AD curve shifts to the right, then the equilibrium quantity of output and the price level

will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the

price level will fall.


7. If households decided to save a larger portion of their income, what effect would this

have on the output, employment, and price level in the short run? What about the

long run?

*In the Short Run…*

-If households save more, they are spending less. Household consumption would decrease

which would shift the Aggregate demand curve to the left. This shift will cause a new ad/as

equilibrium. * If the AD curve shifts to the left, then the equilibrium quantity of output and

the price level will fall.


Also, with this shift, employment would decrease due to a less demand for output.

In the long-run, the saving increase will bring an increase in investment, which is an

important element of productivity. So the AS will shift to the right in the long-run (with the

potential supply vertical line shifting to the right too) . Finally, the total output will increase

again while the price level fall even further.


8. If firms became more optimistic about the future of the economy and, at the same

time, innovation in 3-D printing made most workers more productive, what would the

combined effect on output, employment, and the price-level be?






Note: The answer is in the above link, please find it and paraphrase it.


9. If the US Congress cut taxes at the same time that businesses became more

pessimistic about the economy, what would the combined effect on output, the price

level, and employment be, based on the AD/AS diagram?

– Tax cuts will increase consumption spending and business investment spending. If

businesses are pessimistic and not increasing investment spending with this new incentive,

then the increase in consumption spending will decrease any effects a decrease in business

investment spending would have had. Effectively, the tax cut would keep the aggregate

demand curve in it’s current position and ad/as equilibrium would not change.

Therefore, Price level, output and employment would all remain the same.


6.2 Shifts in Short-run Aggregate Supply

1. Suppose the US Congress passes significant immigration reform that makes it easier

for foreigners to come to the United States to work. Use the AD/AS model to explain

how this would affect the equilibrium level of GDP and the price level.

Immigration reform, as described, should increase the labor supply, shifting SRAS to the

right, leading to a higher equilibrium GDP and a lower price level.


2. Suppose concerns about the size of the federal budget deficit lead the US Congress to

cut all funding for research and development for 10 years. Assuming this has an impact

on technology growth, what does the AD/AS model predict would be the likely effect

on equilibrium GDP and the price level?

Given the assumptions made in the question, the cuts in research and development funding

should reduce productivity growth. The model would show this as a leftward shift in the

SRAS curve, leading to a lower equilibrium GDP and a higher price level.


3. Name some factors that could cause the SRAS curve to shift, and explain whether

they would shift SRAS to the right or to the left.

SRAS will shift to the left because productivity decreases. That leads to a lower output level

(GDP), and a higher price level.


4. Will the shift of SRAS to the right tend to make the equilibrium quantity and price

level higher or lower? What about a shift of SRAS to the left?

If the aggregate supplyalso referred to as the short-run aggregate supply or SRAScurve

shifts to the right, then a greater quantity of real GDP is produced at every price level. If the

aggregate supply curve shifts to the left, then a lower quantity of real GDP is produced at

every price level.


5. What is stagflation?

When an economy experiences stagnant growth and high inflation at the same time

6.3 Summary

2. In a previous lesson it was stated that there is a negative relationship between

unemployment and inflation in the short run. A shock to one of our curves is consistent

with this idea, but a shock to the other curve is not actually consistent with a negative

relationship between unemployment and inflation. What kind of shift is consistent

with this relationship, and which is not?



Shifts in AD are consistent with an inverse relationship between inflation and unemployment,

but this relationship does not hold up when SRAS shifts. We can summarize what happens to

inflation and unemployment when AD and SRAS shift as shown in the table below:


Effect on


Effect on


Consistent with an

inverse relationship?

AD uparrow UR downarrow Inf uparrow YES

AD downarrow UR uparrow Inf downarrow YES

SRAS uparrow UR downarrow Inf downarrow NO

SRAS downarrow UR uparrow Inf uparrow NO

Remember, the inverse relationship between inflation and unemployment exists in the short

run, but not in the long run. We will see this developed within the AD-AS model in our next



3. During the 1970s, the United States was hit with an oil embargo which dramatically

increased the price of energy. Explain how this would impact output, ination, and

the unemployment rate.

The oil embargo would be an example of a negative supply shock. This decreases real GDP

(which means that output decreased), increases unemployment, and increases the aggregate

price level (resulting in inflation). Graphically, the short run supply curve will shift to the

left, meaning that less output will be produced at every price level.


7 Long-run self adjustment in the AD-AS model

1. The economy of Johnsrudia is experiencing a positive output gap caused by an

increase in consumption. Describe the chain of events that would lead the economy to

return to producing its full employment output.

When consumption increases, this will cause AD to increase. The price level will increase as

a result. Higher inflation will lead businesses and workers to believe that prices will be higher

in the future as well, and so wages increase. The change in expectations and inp

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