1 Appendix 14A The Self-Correcting Aggregate Demand and Supply Model ©2004 South-Western

2 1. An assumption of the short-run aggregate supply curve is that it is a period of time which: a. knowledge is complete. b. wages are fixed. c. wages are constant for under one year. d. prices firms charge for products are fixed. B. The short-run aggregate supply curve (SRAS) is based on two assumptions: (1) incomplete knowledge and (2) fixed-wage contracts.

3 2. The long-run aggregate supply curve is based on the assumption that a. both the price level and nominal incomes are fixed. b. prices are flexible after one year. c. both the price level and nominal incomes change by the same percentage. d. potential GDP is undermined. C. The long-run aggregate supply curve (LRAS) is a vertical curve at full-employment real GDP along which profits remain unchanged because the price level and nominal income change proportionally.

4 3. Graphically, long-run macro equilibrium occurs at the a. Midpoint of the aggregate demand curve. b. Intersection of the aggregate demand and long-run aggregate supply curves regardless of the short-run aggregate supply curve. c. mid-point of the long-run aggregate supply curve. d. Intersection of the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves. D. The intersection of these curves establishes the equilibrium price level and full-employment real GDP.

5 4. An increase in nominal incomes of workers results in the a. aggregate demand curve shifting to the left. b. long-run aggregate supply curve shifting to the right. c. short-run aggregate supply curve shifting to the left. d. short-run aggregate supply curve shifting to the right. C. If workers increase their nominal incomes to restore their purchasing power, the higher cost of labor means firms must increase the price level at each possible level of real GDP to maintain profits.

6 5. An increase in aggregate demand in the long-run will result in ____ in full employment real GDP and ____ in the price level. a. no change; an increase. b. an increase; no change. c. a decrease; no change. d. no change; a decrease. A. Since the long-run aggregate supply curve (LRAS) is vertical at full-employment real GDP, an increase in the aggregate demand curve (AD) causes an upward movement along LRAS to establish a higher price level.

7 6. In Exhibit A-7, the intersection of AD 1 with SRAS indicates: a. short-run equilibrium. b. long-run equilibrium. c. that the economy is not operating at full employment. d. that prices and wages are inflexible. B. Long-run equilibrium occurs where the aggregate demand curve (AD 1 ) intersects both the short-run aggregate supply curve (SRAS) and the long-run aggregate supply curve (LRAS). Exhibit A-7 Aggregate Demand and Supply Model

8 7. In Exhibit A-7, the intersection of AD 2 with SRAS indicates: a. short-run equilibrium. b. long-run equilibrium. c. that the economy is operating at full employment. d. that prices and wages are inflexible. A. Since the intersection of aggregate demand curve (AD 2 ) and the aggregate supply curve (SRAS) does not occur along the long-run supply curve (LRAS), it is a short-run equilibrium situation.

9 8. In Exhibit A-7, the self-correcting AD/AS model argument is that, if D 2 equals SRAS, competition: a. from unemployed workers causes an increase in nominal wages and a rightward shift in SRAS. b. from unemployed workers causes a rightward shift in LRAS. c. among firms for workers increases nominal wages and this causes a leftward shift in SRAS. d. among consumers causes an increase in the CPI and a rightward shift in SRAS. A. In short-run equilibrium below full-employment real GDP, unemployed workers will force a lower wage rate causing the short-run aggregate supply curve (SRAS) to shift rightward.

10 9. In Exhibit A-7, the self-correcting AD/AS model theory is that in the long run the economy will a. will remain where SRAS intersects AD 1. b. shift to the intersection of AD 2 and SRAS. c. shift to the intersection of AD 2 and LRAS. d. shift to the intersection of AD 2 and a new leftward- shifted SRAS. C. In the long-run, the rightward shift of the short-run aggregate supply curve (SRAS) will establish long-run equilibrium where the aggregate demand curve (AD 2 ) intersects the long-run aggregate supply curve (LRAS).

In A-7, the self-correcting AD/AS model predicts that the long-run result of the decrease from AD 1 to AD 2 will be a (an) a. higher price level and higher unemployment rate. b. lower price level and higher unemployment rate. c. unchanged price level and full employment. d. lower price level and full employment. D. At any real GDP below the point where the long-run aggregate supply curve (LRAS) intersects the horizontal real GDP axis, the unemployment rate is higher than the full-employment rate. Also, observe that along the vertical axis that the price level (CPI) falls in this case from moving to long-run equilibrium.

Which of the following is the most likely to cause a leftward shift in the long-run aggregate supply curve? a. An increase in labor. b. An increase in capital. c. An advance in technology. d. Destruction of resources. D. A leftward shift in the long-run aggregate supply curve is caused by decreases in resources (land, labor, or capital) that reduces the productive capacity of the economy.

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