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Chapter 12: Q5. (page 258)

Why does a reduction in aggregate demand in the actual economy reduce real output, rather than the price level? Why might a full-strength multiplier apply to a decrease in aggregate demand?

Short Answer

Expert verified

The reduction in aggregate demand in the actual economy reduces real output rather than the price level because the prices are sticky.

A full-strength multiplier applies to a decrease in aggregate demand because prices are not flexible.

Step by step solution

01

Sticky price

The price is sticky in the short run, as it takes time for the economy to absorb the information and then act.A reduction in aggregate demand only reduces the output level but not the prices as the prices are inflexible, i.e., sticky prices.

Suppose it is assumed that prices are inflexible and the aggregate supply curve is horizontal, then a decrease in aggregate demand will not change the price but will reduce the output. The prices do not fall because of several reasons like wage contracts, minimum wage laws, employee morale, fear of price wars, and the “menu cost” notion.

02

Multiplier effect on aggregate demand

When there is no price movement or change, the multiplier effect could act to its full strength on the aggregate demand. Suppose the prices are flexible, then with the change in spending, i.e., reduction in government spending, will reduce the prices. Thus, some individuals will spend more in the economy, diminishing the multiplier effect.

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Most popular questions from this chapter

Which of the following will shift the aggregate supply curve to the right?

  1. A new networking technology increases productivity all over the economy.

  2. The price of oil rises substantially.

  3. Business taxes fall.

  4. The government passes a law doubling all manufacturing wages.

Suppose that consumer spending initially rises by \(5 billion for every 1 percent rise in household wealth and that investment spending initially rises by \)20 billion for every 1 percentage point fall in the real interest rate. Also, assume that the economy’s multiplier is 4. If household wealth falls by 5 percent because of declining house values, and the real interest rate falls by 2 percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level? In what direction and by how much will it eventually shift?

Label each of the following descriptions as being either an immediate-short-run aggregate supply curve, a short-run aggregate supply curve, or a long-run aggregate supply curve.

  1. A vertical line.

  2. The price level is fixed.

  3. Output prices are flexible, but input prices are fixed.

  4. A horizontal line.

  5. An upsloping curve.

  6. Output is fixed.

Use shifts of the AD and AS curves to explain (a) the U.S. experience of strong economic growth, full employment, and price stability in the late 1990s and early 2000s and (b) how a strong negative wealth effect from, say, a precipitous drop in house prices could cause a recession even though productivity is surging.

Explain how an upsloping aggregate supply curve weakens the realized multiplier effect from an initial change in investment spending.
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