MODULE: MACROECONOMICS BB106

Unit 4: Determination of the Level of National Income

Short-answer Problems

1) Explain how GDP would return to equilibrium if it was above or below equilibrium GDP.

Answer:
If GDP were above equilibrium GDP, the total level of GDP produced would be greater than the level of
spending it could generate. This difference means that businesses could not sell all of their stock of goods
and inventories would increase. This situation would encourage businesses to cut back on production and
GDP would decline back to equilibrium GDP.

If GDP were below equilibrium GDP, the total level of GDP is less than the amount of spending generated.
This difference means that buyers are taking goods off the shelves faster than businesses could produce
them. This situation, in turn, would encourage businesses to increase production, raising GDP back to
equilibrium GDP.

2) How does the aggregate expenditures analysis differ from the aggregate demand–aggregate supply
analysis?

Answer:
The aggregate expenditures analysis assumes a constant price level. Output measures are in terms of real
GDP and real income. The aggregate demand – aggregate supply model shows the relationship between
real GDP and the price level. The Keynesian model ignores price level effects of increased aggregate
expenditures. In contrast, the AD – AS model indicates that the price level will rise as aggregate demand
rises in the intermediate or vertical ranges of aggregate supply.

3) How can the aggregate demand curve be derived from the aggregate expenditures model?

Answer:
The AD curve is derived from the intersections of the aggregate expenditure’s curves and the 45-agree
curve. As the price level falls, the aggregate expenditures curves shift upward and the equilibrium real
GDP increases, but as the price level rises, the aggregate expenditures curve shifts downwards and the
equilibrium real GDP decreases. This inverse relationship between the price level and equilibrium real
GDP is the aggregate demand curve.

4) Explain the three reasons given for the downward slope of the aggregate demand curve.

Answer:
The three reasons given are the real-balances effect, the interest-rate effect and the foreign purchases
effect.

The real-balances effect refers to the idea that a higher price level reduces the purchasing power of the
population’s accumulated financial assets. Because of the decline in value of such assets, people will feel
poorer and will reduce their spending. Conversely, as the price level falls the opposite will occur.

The interest-rate effects assume that as the price level rises so will interest rates and rising interest rates
will reduce certain kinds of spending such as consumption spending on durable goods and investment
spending.
The foreign purchases effect assumes that if the price level rises in the U.S. relative to that in foreign
countries, Americans will increase spending on imports at the expense of domestically produced goods and
services and foreign will reduce purchases of U.S. goods. In other words, net exports decline.

5) Define aggregate supply. Describe the characteristics of the aggregate supply curve in the
immediate short-run, short-run and long-run perspectives.

Answer:
AS is the total supply of goods and services that firms in a national economy plan to sell
during a specific time period.

The short-run AS curve is upward sloping because the quantity supplied increase when the
price rises. In the short run, firms have one fixed factor of production. When the curves shift
out what the output and real GDP increase at a given price. As a result, there is a positive
correlation between the price level and output, which is shown on the short run AS curve.

The long run AS curve is vertical which reflect economists’ beliefs that changes in the AD
only temporarily change the economies total output. In the long run, only capital, labor and
technology affect AS because everything in the economy is assumed to be used optimally. The
long run AS curve is static because it is the slowest AS curve

6) What is the effect of the multiplier when aggregate demand increases and there is a large increase
in the price level? What happens when there only is a small increase in the price level?

Answer:
The multiplier effect is weakened with price level changers. In the vertical range of AS, an increase in
AD only produce in increase in the price level but no increase in real output. In the intermediate range,
the increase in AD raises the price level and real output, but real output close not increase by as much as
it would have if there had been no price level increase (as would be the case in the horizontal range. The
conclusion is that the more the price level increases, the less effect any increase in AD will have in
increasing real GDP.

True / False Questions

1) Actual investment consists of planned investment plus unplanned changes in inventories.

Answer: True

2) Exports are a leakage from the circular flow of an economy.

Answer: False

3) The aggregate expenditures model does not allow for cost-push inflation.

Answer: True

4) The interest-rate effect is one of the determinants of aggregate demand.

Answer: False

5) The real-balances effect indicates that inflation makes the public feel wealthier and they therefore
spend more out of their current incomes.

Answer: False
6) If the MPC is 0.8 in a private closed economy, a $30 billion increase in planned
investment will increase equilibrium real GDP by $120 billion.

Answer: False
12. In the above diagram, the economy's immediate-short-run AS curve is line _, its short-run AS
curve is , and its long-run AS curve is line
_.
A.1;2;4
B.1;2;3
C.2;3;4
D.3;2;1

13. In the above diagram, a shift from AS 1 to AS3might be caused by

15. The size of the multiplier associated with an initial increase in spending will
be:
A. the same whether or not inflation occurs.
B. diminished if inflation
occurs.
C. zero if any increase in the price level occurs.
D. enhanced if inflation occurs.