Other things equal, an increase in productivity will shift the aggregate supply curve rightward.

11-1 Why is the aggregate demand curve downsloping? Specify how your explanation differs from the rationale behind the downsloping demand curve for a single product.

The aggregate demand (AD) curve shows that as the price level drops, purchases of real domestic output increase. The AD curve slopes downward for three reasons. The first is the interest-rate effect. We assume the supply of money to be fixed. When the price level increases, more money is needed to make purchases and pay for inputs. With the money supply fixed, the increased demand for it will drive up its price, the rate of interest. These higher rates will decrease the buying of goods with borrowed money, thus decreasing the amount of real output demanded.

The second reason is the wealth or real balances effect. As the price level rises, the real value—the purchasing power—of money and other accumulated financial assets (bonds, for instance) will decrease. People will therefore become poorer in real terms and decrease the quantity demanded of real output.

The third reason is the foreign purchases effect. As the United States’ price level rises relative to other countries, Americans will buy more abroad in preference to their own output. At the same time foreigners, finding American goods and services relatively more expensive, will decrease their buying of American exports. Thus, with increased imports and decreased exports, American net exports decrease and so, therefore, does the quantity demanded of American real output.

These reasons for the downsloping AD curve have nothing to do with the reasons for the downsloping single-product demand curve. In the case of the dropping price of a single product, the consumer with a constant money income substitutes more of the now relatively cheaper product for those whose prices have not changed. Also, the consumer has become richer in real terms, because of the lower price of the one product, and can buy more of it and all other products. But with the AD curve, moving down the curve means all prices are dropping—the price level is dropping. Therefore, the single-product substitution effect does not apply. Also, whereas when dealing with the demand for a single product the consumer’s income is assumed to be fixed, the AD curve specifically excludes this assumption. Movement down the AD curve indicates lower prices but, with regard to the circular flow of economic activity, it also indicates lower incomes. If prices are dropping, so must the receipts or revenues or incomes of the sellers. Thus, a decline in the price level does not necessarily imply an increase in the nominal income of the economy as a whole.

11-2 Explain the shape of the aggregate supply curve, accounting for the differences between the horizontal, intermediate, and vertical ranges of the curve.

In the horizontal range of the aggregate supply (AS) curve, the economy is in a severe recession, so that there is a large GDP gap—much excess capacity—because of deficient aggregate demand (AD). In these circumstances, AD can increase without pulling the price level upward.

In the intermediate, or upsloping, range of the AS curve, the economy is clearly in the recovery phase of the business cycle and the price level moves up more and more as AD increases. The economy as a whole nears the full employment level of output, as some firms, some industries, are at or close enough to their capacity production that they believe they can—or are forced to—raise their prices to equate the quantity they supply with increasing demand. Moreover, some essential inputs are fully employed—some skilled labor, certain raw materials—and firms must bid against each other in order to increase their production. Thus, costs—and prices—start to rise in the economy, pushing up the price level as full employment is reached.

In the vertical range of the AS curve, absolute full capacity has been reached; the economy, by definition, cannot produce any more (not until, through economic growth, the potential output of the economy has increased). Since the economy has attained its potential, any further increase in AD cannot be met by an increase in output. Therefore, the increase in AD results only in pure demand-pull inflation.

11-3 (Optional Section Question) Explain carefully: "A change in the price level shifts the aggregate expenditures curve, but not the aggregate demand curve."

A change in the price level does not shift the aggregate demand curve. It simply represents a movement along the curve, because there is an inverse relationship between the price level and aggregate quantity demanded.

However, a change in the price level will shift the aggregate expenditures curve, which responds to the wealth, interest-rate, and foreign purchases effects occurring with a change in price level. When the price level declines, aggregate expenditures will rise, and when the price level rises, aggregate expenditures will fall. The aggregate expenditures model assumes a constant price level, so it is expressed in "real" terms. Figure 11-2 graphically illustrates the relationship between the two models.

11-4 (Key Question) Suppose that aggregate demand and supply for a hypothetical economy are as shown on top of next page:

An increase in the American price level does not shift the American AD curve. What does happen is that because of the foreign purchases effect, there will be a decline in American net exports and, consequently, movement up along the American AD curve, resulting in a decline in the aggregate quantity demanded of American real output.

A decline in the dollar price of foreign currencies will decrease the price of imported inputs, thereby decreasing the per unit cost of producing American real output. This will shift the American AS curve to the right (and not merely move the economy along an existing AS curve).

11-7 (Key Question) What effects would each of the following have on aggregate demand or aggregate supply? In each case use a diagram to show the expected effects on the equilibrium price level and level of real output. Assume all other things remain constant.

b. A large purchase of wheat by Russia

c. A $1 increase in the excise tax on cigarettes

d. A reduction in interest rates at each price level

e. A cut in Federal spending for health care

f. The expectation of a rapid rise in the price level

g. The complete disintegration of OPEC, causing oil prices to fall by one-half

h. A 10 percent reduction in personal income tax rates

i. An increase in labor productivity

j. A 12 percent increase in nominal wages

k. Depreciation in the international value of the dollar

l. A sharp decline in the national incomes of our western European trading partners

m. A decline in the percentage of the American labor force which is unionized

(a) AD curve left

(b) AD curve right

(c) AS curve left

(d) AD curve right

(e) AD curve left

(f) AD curve right

(g) AS curve right

(h) AD curve right

(i) AS curve right

(j) AS curve left

(k) AD curve right; AS curve left

(l) AD curve left

(m) AS curve right.

b. An increase in aggregate supply (assume prices and wages are flexible)

d. An equal increase in both aggregate demand and aggregate supply

d. A reduction in aggregate demand in the horizontal range of aggregate supply

e. An increase in aggregate demand and a decrease in aggregate supply

f. A decrease in aggregate demand in the intermediate range of aggregate supply (assume prices and wages are inflexible downward)

(a) Price level rises and no change in real output

(b) Price level drops and real output increases

(c) Price level does not change, but real output rises

(d) Price level does not change, but real output declines

(e) Price level increases, but the change in real output is indeterminate

(f) Price level does not change, but real output declines

11-13 "Unemployment can be caused by a leftward shift of aggregate demand or a leftward shift of aggregate supply." Do you agree? Explain. In each case specify price-level effects.

Assuming the economy was not operating in the vertical range of the AS curve, the statement is true. In either case, the new point of intersection is to the left of the previous position, denoting a decrease in real domestic output and, therefore, assuming no change in productivity, necessarily an increase in unemployment.

However, assuming complete flexibility of prices and wages, the decrease in AD will result in a lower price level, whereas the decrease in AS will result in a higher price level. From the point of view of price stability, therefore, the decrease in AD is preferable. If the economy were in the horizontal range initially, there would be no price changes in either case.

11-14 (Last Word) What are the alternative views on why unemployment in Europe has recently been so high? Discuss the policy implications of each view.

There are two views on this question. One is that there is a high natural rate of unemployment in each of the European countries in question. This view holds that there are high levels of frictional and structural unemployment which accompany the full-employment level of output. Any increase in aggregate demand would cause demand-pull inflation. The sources of the high frictional and structural unemployment are government policies and union contracts, which increase the costs of hiring and reduce the costs of not having a job. For example, there are high minimum wages; generous welfare benefits; restrictions against firing, which discourage firms from employing workers; thirty to forty days of paid vacation per year; high worker absenteeism, which reduces productivity; and high employer costs of health, pension, disability, and other benefits.

The second explanation disagrees with the first and sees the major problem as being deficient aggregate demand. Those economists who hold this view point to government policies that are aimed at preventing inflation and not at increasing aggregate demand. In this view, the European economies are operating in the horizontal range of their aggregate supply curves and, increases in aggregate demand would not be inflationary but would, instead, increase output and employment.