CHAPTER 7 : AD-AS CURVES MODEL1. True, False, or Uncertain

a. The aggregate supply relation implies that an increase in output leads to a decrease in a price level.False. Increase in Output (Y) leads to an increase in employment (N), decrease unemployment (U), increase Wages, and leads to increase in Price

(Y) (N) (U) (W) (P)

b. The aggregate demand relation slopes down because at a higher price level, consumers wish to purchase fewer goods.False. In theory, higher price level will shift the LM curve (to right), which means less total amount of money therefore the output will be decreased. This opposite relation between price (P) and output (Y) in aggregate demand relation creates a sloping down curve.

c. The natural level of output can be determined by looking at the aggregate supply relation alone.True. The natural output is defined as level of output when the unemployment is in its natural level, while the other things remain the same. And unemployment level is a determining factor of the aggregate supply.

d. Expansionary monetary policy has no effect on the level of output in the short run.False. A monetary expansion leads to an increase in output in the short term because the increasing in money supply will directly affect to the increasing of output and price level.

e. In the absences of changes in fiscal or monetary policy, the economy will always remain at the natural level of output.False. The change in output is not determined by the policy only. It is also determined by other factors, such as the rise of oil price, the economic condition, the trends applied, some special events/occasions, etc.

f. The neutrality of money in the medium run does not mean that monetary policy cannot or should not be used to affects output.True. It can help the economy to escape from the recession and return more quickly to the natural level of output.

g. In the short run, a reduction in the budget deficit decreases output and decreases the interest rate.

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Yn

IS

LM

IS’

i0

i1

i2

Y’

LM’

A

A’

A”

Yn

AD

AS

AD’

P0

P1

P3

Y’

AS’

A

A’

A”

True. A reduction in budget deficit means a fiscal contraction policy, which leads to decrease in output and therefore decrease interest rate.

3. Suppose the economy begins with output equal to its natural level. Then, there is a reduction in income taxes.a. Effect of a reduction in income taxes on the position of the AD, AS, IS, and LM in medium run.

Income tax reduction means higher income perceived by society. In the short run, increase in income rises consumption, and therefore increase the output (Y). As the output increases, in the medium run the price also increase exceeding the expected wages. Therefore, the wages are

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also increased. The increasing of wages means higher production cost experienced by companies, leads to decrease in output and price increases. These condition is shifting the AS curve to the left to AS’, which moving the point of output back to natural.

b. in the medium run, output level goes back to natural level, interest rate increases price level increases consumption will decrease as the price level goes higher (caused by higher cost of

production, and follows the level of wages) investment will increase as the interest rate goes higher.

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