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Chapter 12: Q7. (page 259)

True or False. Decreases in AD normally lead to decreases in both output and the price level.

Short Answer

Expert verified

The statement is true.

Step by step solution

01

Meaning and shifts in the aggregate demand curve

An aggregate demand curve represents price level at different levels of the real output, which the consumers are willing to pay collectively in the economy. The aggregate demand for an open public economy comprises private consumption, gross investment, government expenditure, and net exports.

The aggregate demand is estimated by what the consumers are paying at the given output level in the economy. A change in any of the components of the aggregate demand causes an overall shift in aggregate demand.

02

Reason for the true statement

As the aggregate demand decreases, the aggregate demand curve shifts from AD to the left (AD’) along the constant supply curve AS. Thus, the economy’s equilibrium shifts from e to e’ along the AS curve.

At the initial equilibrium e, the price level is P, and the real output is Y. As the equilibrium shifts to the left, the price comes down to P’, and the output reduces to Y’.

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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.

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.

What effects would each of the following have on aggregate demand or aggregate supply, other things equal? In each case, use a diagram to show the expected effects on the equilibrium price level and the level of real output, assuming that the price level is flexible both upward and downward.

  1. A widespread fear by consumers of an impending economic depression.

  2. A new national tax on producers based on the value added between the costs of the inputs and the revenue received from their output.

  3. A reduction in interest rates.

  4. A major increase in spending for health care by the federal government.

  5. The general expectation of coming rapid inflation.

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

  7. A 10 percent across-the-board reduction in personal income tax rates.

  8. A sizable increase in labor productivity (with no change in nominal wages).

  9. A 12 percent increase in nominal wages (with no change in productivity).

  10. An increase in exports that exceeds an increase in imports (not due to tariffs).

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.

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?
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