Aggregate Chapter

Supply and
Aggregate
Demand
CHAPTER CHECKLIST
Define and explain the influences on aggregate supply.
Aggregate supply is the output from all firms. Other things remaining the same, the higher the price
level, the greater is the quantity of real GDP supplied and the lower the price level, the smaller is the
quantity of real GDP supplied. The aggregate supply curve is upward sloping and the potential GDP
line is vertical. Moving along the aggregate supply curve, the only influence on production plans that
changes is the price level. All other influences on production plans, such as the money wage rate and
the money prices of other resources, remain constant. Moving along the potential GDP line, when the
price level changes, the money wage rate and the money prices of other resources change by the same
percentage as the price level. Aggregate supply changes and the aggregate supply curve shifts when
potential GDP changes, the money wage rate changes, or the money prices of other resources change.
When the money wage rate or the money prices of other resources rise, aggregate supply decreases.
Define and explain the influences on aggregate demand.
Aggregate demand is the relationship between the quantity of real GDP demanded and the price level.
Other things the same, the higher the price level, the smaller is the quantity of real GDP demanded
and the lower the price level, the greater the quantity of real GDP demanded. A change in the price
level changes in the buying power of money, the real interest rate, and the real prices of exports and
imports, all of which influence the quantity of real GDP demanded. Factors that change aggregate de-
mand and shift the aggregate demand curve are: expectations about the future; fiscal policy and mone-
tary policy; and the state of the world economy. The aggregate demand multiplier is an effect that
magnifies changes in expenditure plans and brings potentially large fluctuations in aggregate demand.
Explain how trends and fluctuations in aggregate demand and aggregate supply
bring economic growth, inflation, and the business cycle.
Macroeconomic equilibrium occurs at the intersection of the aggregate supply and aggregate demand
curves. The macroeconomic equilibrium can be a full-employment equilibrium (real GDP equals po-
tential GDP), an equilibrium with an inflationary gap (real GDP exceeds potential GDP), or an equilib-
rium with a recessionary gap (real GDP is less than potential GDP). In a recessionary gap, the money
wage rate falls so aggregate supply increases and the economy adjusts back to full employment. In an
inflationary gap, the money wage rate rises so aggregate supply decreases and the economy adjusts
back to full employment. Economic growth is the result of growth in potential GDP; inflation is the
result of more rapid growth in aggregate demand than in potential GDP. Fluctuations in aggregate
demand and aggregate supply lead to the business cycle. Demand pull inflation starts with an increase
in aggregate demand, followed by persisting increases in the quantity of money. Cost-push inflation
starts with a decrease in aggregate supply, followed by persisting increases in the quantity of money.

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186 Part 5 . ECONOMIC FLUCTUATIONS

CHECKPOINT 13.1 GDP supplied

increases.
 Define and explain the influences 1b. Changes in the
on aggregate supply. price level
change in the
Quick Review aggregate quan-
• Aggregate supply The relationship between tity supplied
the quantity of real GDP supplied and the and result in
price level when all other influences on movements
production plans remain the same. along the ag-
• Factors that change aggregate supply Ag- gregate supply
gregate supply decreases and the aggre- curve. Aggre-
gate supply curve shifts leftward when gate supply
potential GDP decreases, when the mon- changes and the aggregate supply curve
ey wage rate rises, and when the money shifts when any influence on production
prices of other resources rise. plans other than the price level changes. An
Additional Practice Problem 13.1 increase in the money wage rate decreases
aggregate supply and shifts the aggregate
1. The table shows
Real GDP supply curve leftward, as illustrated by the
the aggregate Price level supplied shift to AS1. A change in the money wage
supply schedule (GDP (billions of rate shifts the aggregate supply curve.
for the United price index) 2005 pounds)
Kingdom. 90 650
a. Plot the 100 700  Self Test 13.1
aggregate 110 750
120 800 Fill in the blanks
supply
130 850 Moving along the aggregate supply curve, as
curve in
the figure. the price level rises, the quantity of real GDP
supplied ____ (decreases; does not change; in-
b. In the figure,
creases) because the real wage rate ____ (falls;
show the ef-
rises). Moving along the potential GDP line, the
fect on the
money wage rate ____ (changes; does not
aggregate
change) when the price level changes. When
supply
potential GDP increases, a ____ (movement
curve of an
along; shift of) the AS curve occurs. When the
increase in
money wage rate changes, a ____ (movement
the U.K.
along; shift of) the AS curve occurs.
money wage
rate. Is there True or false
a movement 1. Along the aggregate supply curve, a rise in
along the the price level decreases the quantity of real
curve or a GDP supplied.
shift of the curve? 2. A rise in the price level decreases potential
GDP.
Solution to Additional Practice Problem 13.1
1a. The aggregate supply curve is plotted in the 3. Anything that changes potential GDP shifts
figure in the next column above as AS0. The the aggregate supply curve.
aggregate supply curve has a positive slope, 4. An increase in potential GDP shifts the ag-
so as the price level rises, the quantity of real gregate supply curve rightward.

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 Chapter 13 . Aggregate Supply and Aggregate Demand 187

Multiple choice
1. Moving along the potential GDP line, the
money wage rate changes by the same per-
centage as the change in the price level so
that the real wage rate
a. increases.
b. decreases.
c. stays at the full-employment equilibrium
level.
d. might either increase or decrease.
e. stays the same, though not necessarily at
the full-employment equilibrium level.
2. The aggregate supply curve is
a. upward sloping.
b. downward sloping.
c. a vertical line.
d. a horizontal line. 5. In Figure 13.1, which of the following might
e. U-shaped. be the reason for the shift of the aggregate
supply curve from AS0 to AS1?
3. When the price level falls, a. a fall in the money wage rate
a. the AS curve shifts rightward but the po- b. an increase in potential GDP
tential GDP line does not shift. c. an increase in investment
b. there is a movement upward along the AS d. a fall in the price of oil
curve. e. a rise in the money wage rate
c. the AS curve shifts leftward but the poten-
tial GDP line does not shift. 6. When potential GDP increases,
d. there is a movement downward along the a. the AS curve shifts rightward.
AS curve. b. there is a movement up along the AS
e. both the potential GDP line and the AS curve.
curve shift leftward. c. the AS curve shifts leftward.
d. there is a movement down along the AS
4. As the price level rises relative to costs and curve.
the real wage rate falls, profits ____ and the e. there is neither a movement along or a
number of firms in business ____. shift in the AS curve.
a. increase; increases
7. If the money wage rate rises,
b. increase; decreases
a. the AS curve shifts rightward.
c. decrease; increases
b. there is a movement up along the AS
d. decrease; decreases
curve.
e. do not change; do not change
c. the AS curve shifts leftward.
d. there is a movement down along the AS
curve.
e. there is neither a movement along nor a
shift in the AS curve.

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188 Part 5 . ECONOMIC FLUCTUATIONS

Complete the graph

Quantity of real
Price level GDP supplied Potential GDP
(GDP price index (trillions of (trillions of
2005 = 100) 2005 dollars) 2005 dollars)
140 17 13
130 15 13
120 13 13
110 11 13
100 9 13

Additional Exercises (also in MyEconLab Test A)

1. Many events have followed the ending of
apartheid in South Africa. Explain the effect
of each of the following events on South Af-
rica’s aggregate supply.
a. U.S. businesses have established branches
in South Africa.
b. The price level has increased.
c. Unemployment decreased.
1. The table above gives the aggregate supply d. Money wage rates have increased.
schedule and potential GDP schedule for a e. Tourism increased, and many new hotels
nation. were built.
a. Label the axes and then plot the AS curve f. AIDS became more prevalent.
and potential GDP line in Figure 13.2.
b. Suppose the money wage rate falls. Show
CHECKPOINT 13.2
the effect of this change on aggregate sup-
ply and potential GDP in Figure 13.2.
c. Use the data in the table to again plot the  Define and explain the influences on
AS curve and potential GDP line in Figure aggregate demand.
13.3. Be sure to label the axes.
d. Potential GDP increases by $2 trillion. Show Quick Review
the effect of this change on aggregate sup- • Factors that change aggregate demand Ag-
ply and potential GDP in Figure 13.3. gregate demand changes and the aggre-
gate demand curve shifts if expected fu-
Short answer and numeric questions ture income, expected future inflation, or
1. Why does the AS curve slope upward? expected future profit change; if the gov-
2. Why does the aggregate supply curve shift ernment or the Federal Reserve take
when the money wage rate rises? Why steps that change expenditure plans,
doesn’t the potential GDP line also shift? such as changes in taxes or in the quanti-
ty of money; or the state of the world
3. What is the effect on aggregate supply if the economy changes.
money price of oil rises?

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 Chapter 13 . Aggregate Supply and Aggregate Demand 189

Additional Practice Problem 13.2 consumption expenditure. Aggregate de-

1. Draw aggregate demand curves and illustrate mand increases and the aggregate demand
the effects of each event listed below either by a curve shifts rightward, as illustrated in the
movement along the aggregate demand curve previous answer.
or a shift in the aggregate demand curve. These
events are:  Self Test 13.2
a. The price level falls. Fill in the blanks
b. Firms increase their investment because An increase in the price level ____ (decreases;
the expected profit increases. increases) the quantity of real GDP demanded
c. The government cuts its taxes. and a ____ (movement along; shift of ) the ag-
gregate demand curve occurs. An increase in
Solution to Additional Practice Problem 13.2 expected future income shifts the AD curve
1a. To answer this Practice Problem, remember ____ (leftward; rightward). A tax cut shifts the
that a change in any factor that influences AD curve ____ (leftward; rightward). A de-
expenditure plans other than the price level crease in foreign income shifts the AD curve
brings a change in aggregate demand and a ____ (leftward; rightward).
shift in the AD curve. In this part, it is the
price level that changes, so there is a change True or false
in the quantity of real GDP demanded and a 1. As the price level falls, other things remain-
movement ing the same, the quantity of real GDP de-
along the ag- manded increases.
gregate de- 2. An increase in expected future income will
mand curve. not increase aggregate demand until the in-
Because the come actually increases.
price level falls, 3. A decrease in government expenditure shifts
there is a the aggregate demand curve rightward.
downward 4. An increase in Mexican income decreases
movement aggregate demand in the United States be-
along the ag- cause Mexicans will buy more Mexican-
gregate de- produced goods.
mand curve, as
illustrated by the grey arrow in the figure. Multiple choice
1b. An increase in 1. When the price level rises there is a ____ the
firms’ invest- aggregate demand curve.
ment increases a. rightward shift of
aggregate de- b. movement down along
mand. The ag- c. leftward shift of
gregate de- d. movement up along
mand curve e. rotation of
shifts right-
ward, as 2. A rise in the price level
shown in the a. raises the buying power of money.
figure by the b. decreases the prices of exports.
shift from AD0 c. lowers the buying power of money.
to AD1. d. increases aggregate demand.
1c. When the government cuts its taxes, house- e. makes the aggregate demand curve
holds’ incomes rise and so they increase their steeper.

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190 Part 5 . ECONOMIC FLUCTUATIONS

3. When the price level rises, the real interest 6. Which of the following shifts the aggregate
rate ____ and the quantity of real GDP de- demand curve leftward?
manded ____. a. a decrease in government expenditure on
a. rises; increases goods and services
b. rises; decreases b. an increase in the price level
c. falls; increases c. a tax cut
d. falls; decreases d. an increase in foreign income
e. does not change; does not change e. a decrease in the price level
7. When investment increases, the ____ in ag-
gregate demand is ____ the change in in-
vestment.
a. increase; greater than
b. increase; smaller than
c. increase; the same as
d. decrease; the same as
e. decrease; greater than

Complete the graph

4. In Figure 13.4, the shift in the aggregate de-

mand curve could be the result of
a. an increase in the quantity of money
b. a decrease in foreign incomes.
c. a tax hike.
d. a fall in the price level.
e. a decrease in the expected future rate of
profit.

5. A change in any of the following factors,

EXCEPT ____, shifts the aggregate demand 1. Figure 13.5 shows an aggregate demand
curve. curve.
a. expectations about the future a. Suppose that government expenditure on
b. the money wage rate goods and services increase. In Figure
c. monetary and fiscal policy 13.5, illustrate the effect of this fiscal poli-
d. foreign income cy.
e. the foreign exchange rate b. Suppose the Federal Reserve decreases the
quantity of money. In Figure 13.5, illus-
trate the effect of this monetary policy.

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 Chapter 13 . Aggregate Supply and Aggregate Demand 191

Short answer and numeric questions Additional Practice Problem 13.3

1. Why does an increase in the price level de- 1. The table has
Real Real
crease the quantity of real GDP demanded? the U.K.
Price GDP GDP
2. Expected future profit increases. Explain the aggregate de- level demanded supplied
effect on aggregate demand. mand and ag- (GDP (billions of
3. The government increases its taxes. What is gregate supply price index) 2005 pounds)
schedules. 90 800 650
the effect on aggregate demand?
a. Plot the 100 775 700
4. What is the aggregate demand multiplier? aggregate 110 750 750
120 725 800
Additional Exercises (also in MyEconLab Test A) demand
curve and 130 700 850
1. Explain the effect on Japan’s aggregate de-
mand of each of the following events, one at the aggregate
a time. supply curve
a. The price level in Japan rises. in the figure.
b. The Asian economies experience very b. What is the
strong growth. macroeco-
c. Japan adopts an expansionary fiscal policy nomic equi-
and cuts taxes. librium?
c. If U.K. poten-
2. Explain the effect on China’s aggregate de-
tial GDP is
mand of each of the following events, one at
£800 billion,
a time.
what is the
a. The United States goes into recession.
type of mac-
b. Japanese and European firms establish roeconomic
new plants in China. equilibrium?
c. The Chinese yuan strengthens against the d. If the government increases its expendi-
U.S. dollar. ture on goods and services, what is the ef-
fect on the British economy?

CHECKPOINT 13.3 Solution to Additional Practice Problems 13.3

1a. The aggregate
 Explain how trends and fluctuations demand curve is
in aggregate demand and aggregate in the figure. It
has a negative
supply bring economic growth, slope, so as the
inflation, and the business cycle. price level falls,
the quantity of
Quick Review real GDP de-
• Recessionary gap A gap that exists when manded in-
potential GDP exceeds real GDP. To re- creases. The ag-
store full employment, the money wage gregate supply
rate falls and aggregate supply increases. curve also is
• Inflationary gap A gap that exists when plotted in the
real GDP exceeds potential GDP. To re- figure. It has a positive slope, so as the price
store full employment, the money wage level rises, the quantity of real GDP supplied
rate rises and aggregate supply decreases. increases.

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192 Part 5 . ECONOMIC FLUCTUATIONS

1b. The macroeconomic equilibrium is at a price 2. In the AS-AD model, economic growth is
level of 110 and real GDP of £750 billion. The demonstrated by persisting rightward
macroeconomic equilibrium is at the inter- movements of the AD curve.
section of the aggregate supply curve and the 3. Aggregate demand fluctuations are the main
aggregate demand curve. source of the business cycle.
1c. Potential GDP is 4. Demand-pull inflation starts with an increase
£800 billion and in aggregate demand that leads to an infla-
the macroeco- tionary gap.
nomic eq- 5. To persist, cost-push inflation does not need
uilibrium real persisting increases in aggregate demand.
GDP is £750 bil-
6. In the financial crisis of 2008, the Fed took ac-
lion, so as the
tion to bail out financial institutions and
figure shows, the
doubled the monetary base.
economy is in a
below full- Multiple choice
employment 1. If the quantity of real GDP supplied equals
equilibrium. Re- the quantity of real GDP demanded, then
al GDP is less than potential GDP. a. nominal GDP must equal real GDP.
1d. If the government increases its expenditure b. real GDP must equal potential GDP.
on goods and services, aggregate demand in- c. real GDP must be greater than potential
creases and the aggregate demand curve GDP.
shifts rightward. The price level rises and re- d. real GDP might be greater than, equal to,
al GDP increases, moving the nation closer to or less than potential GDP.
a full-employment equilibrium. e. real GDP must be less than potential GDP.
2. An inflationary gap is created when
 Self Test 13.3 a. real GDP is greater than potential GDP.
Fill in the blanks b. real GDP equal to potential GDP.
Macroeconomic equilibrium occurs where the c. the inflation rate is less than potential in-
AD curve intersects ____ (the AS curve; poten- flation.
tial GDP line). When real GDP exceeds potential d. the price level exceeds the equilibrium
GDP, ____ (an inflationary; a recessionary) gap price level.
exists. When potential GDP exceeds real GDP, e. potential GDP is greater than real GDP.
____ (an inflationary; a recessionary) gap exists.
If aggregate demand grows more rapidly than 3. The economy is at full employment. Aggre-
potential GDP, the result is ____. An increase in gate demand increases, so ____ is created
government expenditure on goods and services and the adjustment to full employment oc-
might start a ____ (demand-pull; cost-push) in- curs because ____.
flation. An increase in the money price of oil a. an inflationary gap; the AS curve shifts
might start a ____ (demand-pull; cost-push) in- leftward as the money wage rate rises
flation. Stagflation is a combination of ____ (ex- b. an inflationary gap; the AD curve shifts
pansion; recession) and a ____ (falling; rising) leftward
price level. During the ____ (Great Depression; c. an inflationary gap; potential GDP in-
financial crisis of 2008) the Fed took no action. creases to close the gap
d. a recessionary gap; the AS curve shifts
True or false leftward as the money wage rate falls
1. A recessionary gap has a shortage of labor. e. a recessionary gap; the AS curve shifts
leftward as the money wage rate rises

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 Chapter 13 . Aggregate Supply and Aggregate Demand 193

7. The main source of business cycle fluctua-

tions is
a. fluctuations in aggregate demand.
b. persisting growth in aggregate demand.
c. persisting growth in potential GDP
d. fluctuations in aggregate supply.
e. persisting growth in aggregate supply.
8. A cost-push inflation can be started by ____.
a. an increase in the quantity of money
b. a fall in the money price of oil
c. an increase in potential GDP
d. a rise in the money price of oil
e. an increase in U.S. exports
9. Stagflation is a combination of ____ real GDP
and a ____ price level.
4. In Figure 13.6, the equilibrium price level is
a. increasing; rising
____ and the equilibrium real GDP is ____
b. increasing; falling
trillion.
c. decreasing; rising
a. 110; $13 d. decreasing; falling
b. 110; $15 e. no change in; rising
c. 100; $14
d. 90; $13 Complete the graph
e. 90; $15
5. Figure 13.6 shows
a. a full-employment equilibrium.
b. an above full-employment equilibrium
with an inflationary gap.
c. an above full-employment equilibrium with
a recessionary gap.
d. a below full-employment equilibrium with
an inflationary gap.
e. a below full-employment equilibrium with
a recessionary gap.
6. The adjustment from a recessionary gap to
full employment requires the money wage
rate to ____, which then ____.
a. rise; decreases aggregate supply
b. rise; increases aggregate demand
c. fall; decreases aggregate demand 1. Use Figure 13.7 to show the effect of an in-
d. fall; increases potential GDP crease in expected future profit on the price
e. fall; increases aggregate supply level and real GDP. Does this change create
an inflationary gap or a recessionary gap? In
the figure, show how the economy returns to
potential GDP.

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194 Part 5 . ECONOMIC FLUCTUATIONS

5. What was the difference in the Fed’s behav-

ior during the Great Depression contrasted to
the Fed’s behavior during the 2008 financial
crisis?
6. The Eye on Your Life on discussed some of
the uses you can make of the AS-AD model.
Another use lies in the political arena. For in-
stance, if a politician is running a campaign
in which he or she suggests raising taxes, us-
ing the AS-AD model, what do you expect
will happen to real GDP if this campaign
promise is carried out?

Additional Exercises (also in MyEconLab Test A)

The Canadian economy is at full employment
when the following events occur:
2. Use Figure 13.8 to show the effect a rise in a. The world economy goes into a strong ex-
the price of oil has on the price level and real pansion.
GDP. Does this change create an inflationary b. Canadian businesses expect future profits
gap or a recessionary gap? to rise.
1. Explain the effect of each event separately on
Short answer and numeric questions
real GDP, the price level, and unemployment
1. What is an inflationary gap and how is it
in Canada in the short run.
eliminated?
2. If the events occur separately, explain the ad-
2. Why is growth in the quantity of money nec-
justment that occurs in each case in the long
essary to sustain a demand-pull inflation?
run.
3. What is the difference between a demand-
3. Explain the combined effect of these events
pull inflation and a cost-push inflation? How
on Canadian real GDP and price level.
are they similar?
4. What is stagflation? What can create stagfla-
tion?

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 Chapter 13 . Aggregate Supply and Aggregate Demand 195

SELF TEST ANSWERS

 CHECKPOINT 13.1 supply curve is labeled AS; page 323.
b. The fall in the money wage rate has no ef-
Fill in the blanks
fect on potential GDP, so the potential
Moving along the aggregate supply curve, as
GDP line does not change. Aggregate
the price level rises, the quantity of real GDP
supply, however, increases so the AS
supplied increases because the real wage rate
curve shifts rightward, to an AS curve
falls. Moving along the potential GDP line, the
such as AS1; page 326.
money wage rate does not change when the
price level changes. When potential GDP in-
creases, a shift of the AS curve occurs. When the
money wage rate changes, a shift of the AS
curve occurs.
True or false
1. False; pages 322-323
2. False; pages 322-323
3. True; page 325
4. True; page 325

Multiple choice
1. c; pages 322-323
2. a; page 323
3. d; pages 322-323
4. a; page 324 c. Figure 13.10 labels the axes. The aggregate
5. e; page 326 supply curve is labeled AS; page 323.
6. a; page 325 d. The potential GDP line shifts rightward by
7. c; page 326 $2 trillion, as indicated by the shift to Po-
tential GDP1. The aggregate supply curve
Complete the graph also shifts rightward by $2 trillion, as
shown by the shift to AS1; page 325.

Short answer and numeric questions

1. A movement along the AS curve brings a
change in the real wage rate (and changes in
the real cost of other resources whose money
prices are fixed).
If the price level rises and the money wage
rate does not change, an extra hour of labor
that was previously unprofitable becomes
profitable. So, the quantity of labor demand-
ed increases and production increases.
In addition, if the price level rises and the
money wage rate does not change, the real
wage rate falls. A fall in the real wage rate
boosts firms’ profits. With the increase in
1. a. Figure 13.9 labels the axes. The aggregate profit, the number of firms in business in-

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196 Part 5 . ECONOMIC FLUCTUATIONS

creases. Finally fewer firms will shut down  CHECKPOINT 13.2

and more firms will open. All these changes
increase the quantity of real GDP supplied. Fill in the blanks
So as the price level rises, the quantity of real An increase in the price level decreases the
GDP supplied increases; pages 322-324. quantity of real GDP demanded and a move-
ment along the aggregate demand curve occurs.
2. An increase in the money wage rate increases
An increase in expected future income shifts the
firms’ costs. The higher are firms’ costs, the
AD curve rightward. A tax cut shifts the AD
smaller is the quantity that firms are willing
curve rightward. A decrease in foreign income
to supply at each price level. Aggregate sup-
shifts the AD curve leftward.
ply decreases and the AS curve shifts left-
ward. A change in the money wage rate does True or false
not change potential GDP. Potential GDP 1. True; page 328
depends only on the economy’s real ability 2. False; page 330
to produce and on the full-employment
3. False; page 331
quantity of labor, which occurs at the equi-
librium real wage rate. The equilibrium real 4. False; page 332
wage rate can occur at any money wage rate; Multiple choice
pages 325-326. 1. d; page 328
3. If the money price of oil rises, firm’s costs in- 2. c; pages 328-329
crease. The higher firms’ costs, the smaller 3. b; pages 329-330
the quantity of goods and services that firms 4. a; page 331
will supply at each price level. Aggregate 5. b; pages 330-331
supply decreases and the aggregate supply
6. a; pages 330-331
curve shifts leftward; page 326.
7. a; page 332
Additional Exercises (also in MyEconLab Test A) Complete the graph
1. a. Establishing more branches of businesses
within South Africa increases the number
of business and increases aggregate sup-
ply; page 324.
b. In the short run, the increase in the price
level increases the aggregate quantity
supplied; page 325.
c. As unemployment decreases and em-
ployment increases, production increases
and aggregate supply increases; page 322.
d. An increase in money wage rates decreas-
es aggregate supply; pages 325-326 .
e. As tourism increases and new hotels are
built, the quantity capital increases so that
potential GDP increases and thereby ag-
gregate supply increases; pages 322, 325.
f. The spread of AIDS decreases the quantity 1. a. An increase in government expenditure
of labor. As a result, potential GDP de- on goods and services increases aggregate
creases so that aggregate supply decreas- demand and shifts the AD curve right-
es; page 322. ward, in Figure 13.11 from AD to AD1;
page 331.

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 Chapter 13 . Aggregate Supply and Aggregate Demand 197

b. A decrease in the quantity of money de- b. The new plants will have the first order
creases aggregate demand and shifts the effect of increasing China’s potential GDP
AD curve leftward, in Figure 13.11 from and its aggregate supply.
AD to AD2; page 331. c. A stronger yuan makes China’s exports
Short answer and numeric questions more expensive and imports from the
1. An increase in the price level decreases the United States cheaper to residents of Chi-
quantity of real GDP demanded because an na. Chinese exports decrease and imports
increase in the price level lowers the buying increase, which decreases China’s aggre-
power of money, raises the real interest rate, gate demand and shifts the AD curve
raises the real prices of exports, and lowers leftward; page 331.
the real price of imports; pages 328-330.
2. An increase in expected future profit increas-  CHECKPOINT 13.3
es the firms’ investment and thereby increas- Fill in the blanks
es aggregate demand; page 330. Macroeconomic equilibrium occurs where the
3. The government can influence aggregate AD curve intersects the AS curve. When real
demand by changing taxes. When the gov- GDP exceeds potential GDP, an inflationary
ernment increases taxes, aggregate demand gap exists. When potential GDP exceeds real
decreases; page 331. GDP, a recessionary gap exists. If aggregate
4. The aggregate demand multiplier is an effect demand grows more rapidly than potential
that magnifies changes in expenditure and GDP, the result is inflation. An increase in gov-
increases fluctuations in aggregate demand. ernment expenditure on goods and services
For example, an increase in investment in- might start a demand-pull inflation. An in-
creases aggregate demand and increases in- crease in the money price of oil might start a
come. The increase in income induces an in- cost-push inflation. Stagflation is a combination
crease in consumption expenditure so aggre- of recession and a rising price level. During the
gate demand increases by more than the ini- Great Depression the Fed took no action.
tial increase in investment; page 332.
True or false
Additional Exercises (also in MyEconLab Test A) 1. False; page 335
1. a. The increase in the Japanese price level 2. False; page 336
makes Japanese-made goods more expen-
3. True; page 337
sive. Japan’s exports decrease and Japan’s
imports increase, and there is a movement 4. True; page 338
up along Japan’s AD curve; page 330. 5. False; page 339
b. As the rest of Asia experiences strong eco- 6. True; page 340
nomic growth, the demand for Japanese
Multiple choice
exports increases. Japan’s aggregate de-
mand increases and the AD curve shifts 1. d; page 335
rightward; page 332. 2. a; page 335
c. An expansionary fiscal policy and tax cuts 3. a; page 335
increase aggregate demand and the AD 4. c; page 335
curve shifts rightward; page 331. 5. b; page 335
2. a. As the United States goes into recession, 6. e; page 335
the demand for Chinese exports decreases. 7. a; page 337
China’s aggregate demand decreases and 8. d; page 339
the AD curve shifts leftward; page 332.
9. c; page 339

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198 Part 5 . ECONOMIC FLUCTUATIONS

Complete the graph in Figure 13.13, in which the AS curve shifts

leftward. Eventually the AS curve shifts to
AS1. Real GDP returns to potential GDP, $13
trillion, and the price level rises to 120; pages
330, 335.

2. Figure 13.14 shows the effect of a rise in the

price of oil. Aggregate supply decreases and
the AS curve shifts leftward from AS to AS1.
Real GDP decreases to $12 trillion and the
price level rises to 110. A recessionary gap is
created because real GDP is less than poten-
tial GDP; pages 326, 335.
Short answer and numeric questions
1. An inflationary gap exists when real GDP
exceeds potential GDP. Employment in the
labor market exceeds full employment, so
the money wage rate starts to rise. As the
1. An increase in expected profit increases money wage rate rises, aggregate supply de-
firms’ investment. Investment is part of ag- creases and the aggregate supply curve shifts
gregate demand, so the increase in in- leftward. Eventually, real GDP returns to po-
vestment increases aggregate demand. The tential GDP and the inflationary gap is elim-
aggregate demand curve shifts rightward, inated; page 335.
from AD to AD1 in Figure 13.12. Aggregate
2. Demand-pull inflation starts with an increase
supply does not change, so in the figure the
in aggregate demand which raises the price
equilibrium price level rises to 110 and equi-
level. In order for an inflation to occur, the
librium real GDP increases to $14 trillion.
price level must persistently continue to rise.
An inflationary gap now exists because there
The only factor that can create an on-going
is an above-full employment equilibrium.
increase in the price level is (persisting) in-
The money wage rate rises and aggregate
creases in the quantity of money because
supply decreases. This change is illustrated

© 2013 Pearson Education, Inc. Publishing as Addison Wesley

 Chapter 13 . Aggregate Supply and Aggregate Demand 199

they create (persisting) increases in aggregate b. A rise in expected future profits increases
demand and thereby (persisting) increases in Canada’s aggregate demand. The price
the price level; page 338 level and real GDP both increase. In the
3. The difference between demand-pull and short run, unemployment decreases; pag-
cost-push inflation can be traced to what es 330-331, 335.
starts the inflationary process. In a demand- 2. a. A strong expansion in the world economy
pull inflation, the inflation starts with an increases Canada’s aggregate demand
event that increases aggregate demand. In a and, in the short run, tightens the labor
cost-push inflation, the inflation starts with market so there is a shortage of labor. As
an event that decreases aggregate supply. A time passes, the money wage rate rises,
demand-pull inflation and cost-push infla- raising the real wage rate and decreasing
tion are similar because both need constant aggregate supply. In the long run the
increases in the quantity of money to create a money wage rate has risen enough to de-
persisting inflation; pages 338-339. crease aggregate supply and shift the AS
4. Stagflation is a combination of recession (fall- curve enough so that real GDP returns to
ing real GDP) and inflation (rising price lev- potential GDP. The price level rises so that
el). Stagflation can be created by a decrease in the long run it is higher than what it
in aggregate supply, that is, a leftward shift was both initially and in the short run;
of the aggregate supply curve; page 339. page 335.
5. During the Great Depression, the Fed did lit- b. A rise in expected future profits increases
tle or nothing. The quantity of money con- Canada’s aggregate demand and, in the
tracted by a huge amount and aggregate short run, tightens the labor market so
demand collapsed. The result was that real there is a shortage of labor. The shortage
GDP plummeted. During the financial crisis of labor puts upward pressure on the
of 2008, the Fed actively bailed out financial money wage rate, so the money wage rate
institutions and doubled the monetary base rises. As the money wage rate rises, ag-
so that the quantity of money continued to gregate supply decreases and the AS curve
grow. Aggregate demand decreased but did shifts leftward. In the long run, real GDP
not collapse; page 340. returns to potential GDP. The price level,
however, rises so that in the long run it is
6. If the politician is elected and, as a result, higher than what it was both initially and
taxes are raised, then aggregate demand de- in the short run; page 335.
creases and the AD curve shifts leftward. As
a result, real GDP decreases. 3. In the short run, both events increase Cana-
da’s real GDP and the price level, so Cana-
Additional Exercises (also in MyEconLab Test A) da’s real GDP and the price level rise. In the
1. a. A strong expansion in the world economy long run, for both events Canada’s real GDP
increases Canada’s aggregate demand be- returns to potential GDP and the price level
cause it increases Canadian exports. The rises, so in the long run there is no change in
price level and real GDP both increase. In Canada’s real GDP but the price level rises;
the short run, unemployment decreases; pages 330-332, 335.
pages 331-332, 335.

© 2013 Pearson Education, Inc. Publishing as Addison Wesley