True or False: President Roosevelt was trying to increase aggregate demand. True False 3. Problems and Applications Q5 True or False: Whenever the economy enters a recession, its long-run aggregate supply curve shifts to the left. True False 4. Problems and Applications Q7 The economy begins in long-run equilibrium. Then one day, the president appoints a new Fed chair, who is well known for holding the view that inflation is not a major problem for an economy. Note: You will not be graded on any changes you make to the following graph, but you may use it to help you understand the scenario described. LRAS Aggregate Supply Aggregate Demand Aggregate Supply Price Level LRAS Aggregate Demand Quantity of Output Which of the following statements accurately describes what would happen as a result of this news? Check all that apply. People would expect the price level to fall. a WWhich of the following statements accurately describes what would happen as a result of this news? Check all that apply. People would expect the price level to fall. The nominal wage that workers and firms agree to in their new labor contracts would be higher than it would be otherwise. The profitability of producing goods and services at any given price level would decrease. The short-run aggregate-supply curve would shift to the right. If aggregate demand is held constant, the shift in the aggregate-supply curve will cause the price level to RISE OR FALL and the quantity of output produced to RISE OR FALL 5. Economic fluctuations | The following graph shows a hypothetical economy in long-run equilibrium at an expected price level of 120 and a natural output level of $600 billion. Suppose firms become pessimistic about future business conditions and cut back on investment spending. Using the graph, shift the short-run aggregate supply (AS) curve or the aggregate demand (AD) curve to show the short-run impact of the business pessimism. Aggregate supply - SHIFT LEFT OR SHIFT RIGHT OR NO CHANGE Aggregate demand - SHIFT LEFT OR SHIFT RIGHT OR NO CHANGE 240 a WIn the short run, the decrease in investment spending associated with business pessimism causes the price level to RISE ABOVE OR FALL BELOW the price level people expected and the quantity of output to RISE ABOVE OR FALL BELOW the natural level of output. The business pessimism will cause the unemployment rate to RISE ABOVE OR FALL BELOW the natural rate of unemployment in the short run. Again, the following graph shows a hypothetical economy experiencing long-run equilibrium at the expected price level of 120 and natural output level of $600 billion, prior to the decrease in investment spending associated with business pessimism. Along the transition from the short run to the long run, price-level expectations will ADJUST UPWARD OR ADJUST DOWNWARD OR REMAIN THE SAME and the AGGREGATE DEMAND OR SHORT-RUN AGGREGATE SUPPLY curve will shift to the LEFT OR RIGHT Using the graph, illustrate the long-run impact of the business pessimism by shifting both the aggregate demand (AD) curve and the short-run aggregate supply (AS) curve in the appropriate directions. 240 O AS 200 AD 160 AS PRICE LEVEL 120 80 AD 40 200 400 600 800 1000 1200 OUTPUT (Billions of dollars) Aggregate supply - SHIFT LEFT OR SHIFT RIGHT OR NO CHANGE Aggregate demand - SHIFT LEFT OR SHIFT RIGHT OR NO CHANGE In the long run, due to the business pessimism, the price level INCREASES OR DECREASES OR REM AINS THE SAME, the quantity of output EXCEEDS OR aRETURNS TO OR FALLS SHORT OF the natural level of output, and the unemployment rate EXCEEDS OR RETURNS TO OR FALLS SHORT OF the natural rate. 6. The opportunity cost of holding money Suppose you've just inherited $5,000 from a relative. You're trying to decide whether to put the $5,000 in a non-interest-bearing account so that you can use it whenever you want (that is, hold it as money) or to use it to buy a U.S. Treasury bond. The opportunity cost of holding the inheritance as money depends on the interest rate on the bond. For each of the interest rates in the following table, compute the opportunity cost of holding the $5,000 as money. Interest Rate on Government Bond Opportunity Cost (Percent) (Dollars per year) 9 0.09 or 55,556.00 or 450.00 or 5,000 or 9.00 11 45,455.00 or 11.00 or 550.00 or 5,000 or 0.11 What does the previous analysis suggest about the market for money? The supply of money is independent of the interest rate. The quantity of money demanded increases as the interest rate rises. The quantity of money demanded decreases as the interest rate rises. 7. The theory of liquidity preference and the downward-sloping aggregate demand curve Suppose the money market for some hypothetical economy is given by the following graph, which plots the money demand and money supply curves. Assume the central bank in this economy (the Fed) fixes the quantity of money supplied. Suppose the price level increases from 90 to 105. Shift the appropriate curve on the graph to show the impact of an increase in the overall price level on the market for money. Money demand shifts - RIGHT OR LEFT OR NO CHANGE a W12 Money Supply O 10 Money Demand Co Money Supply INTEREST RATE (Percent) Money Demand N 20 40 80 100 120 MONEY (Billions of dollars) Following the price level increase, the quantity of money demanded at the initial interest rate of 6% will be GREATER OR LESS than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to INCREASE OR DECREASE their money holdings. In order to do so, they will BUY OR SELL bonds and other interest-bearing assets, and bond issuers will realize that they HAVE TO OFFER HIGHER OR CAN OFFER LOWER interest rates until equilibrium is restored in the money market at an interest rate of I The following graph plots the aggregate demand curve for this economy. Show the impact of the increase in the price level by moving the point along the curve or shifting the curve. AGGREGATE DEMAND CURVE - SHIFTS ALONG THE CURVE OR SHIFTS RIGHT OR SHIFTS LEFT a WNew MS Curve Money Demand 5.0 4.5 New Equilibrium INTEREST RATE (Percent) 4.0 3.5 30 2.5 Money Supply 0.2 0.3 0.4 0.5 0.6 0.7 0.8 MONEY (Trillions of dollars) Suppose the Fed announces that it is lowering its target interest rate by 75 basis points, or 0.75 percentage points. To do this, the Fed will use open-market operations to INCREASE OR DECREASE the SUPPLY OF OR DEMAND FOR money by BUYING BONDS FROM OR SELLING BONDS TO the public. Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money. Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a lower interest rate will REDUCE OR INCREASE the cost of borrowing, causing residential and business investment spending to INCREASE OR DECREASE and the quantity of output demanded to INCREASE OR DECREASE at each price level. Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand. AGGREGATE DEMAND - SHIFTS RIGHT OR SHIFT LEFT OR NO CHANGE a WAggregate Demand PRICE LEVEL Aggregate Demand OUTPUT Suppose the governments of two very similar economies, economy Y and economy Z, implement a permanent tax cut of equal size. Investment spending in economy Y is more sensitive to changes in the interest rate than investment spending in economy Z. The economies are otherwise completely identical. The tax cut will have a larger impact on aggregate demand in the economy with the LOWER SENSITIVITY TO CHANGES IN HE INTEREST RATE OR HIGHER SENSITIVITY TO CHANGE IN THE INTEREST RATE. 10. Using policy to stabilize the economy The government possesses the tools necessary to influence the output level in the short run through use of monetary and fiscal policy. However, there is some debate regarding whether the government should attempt to stabilize the economy. Which of the following are arguments in favor of active stabilization policy by the government? Check all that apply. The current tax system acts as an automatic stabilizer. Businesses make investment plans many months in advance Shifts in aggregate demand are often the result of waves of pessimism or optimism among consumers and businesses a W