Aggregate Demand (AD)
What does the aggregate demand curve show about the relationship between the price level and total planned spending (consumers, businesses, government, and foreign sector)?
It shows the level of spending by consumers, businesses, government, and the foreign sector at different price levels (downward-sloping AD).
If wages and input prices are sticky in the short run, how does an increase in the overall price level affect short-run output?
Firms see higher product prices but fixed nominal costs, profits rise and they increase production (movement up SRAS to higher real output).
What does the vertical LRAS represent?
The economy’s potential or full-employment real GDP (maximum sustainable capacity) — output independent of price level in the long run.
What fiscal policy tool would the government use to fight a recession? Expansionary or contractionary? Give one example.
Expansionary fiscal policy — increase government spending or decrease taxes.
What is an automatic stabilizer? Give a simple example.
A program that counteracts the business cycle without new government action — e.g., unemployment insurance, progressive income taxes.
Explain the wealth effect component of why the AD curve slopes downward.
As price level falls, real wealth (purchasing power of money balances) rises, increasing consumption and thus quantity demanded of real GDP.
What happens to SRAS when business taxes increase? Movement or shift? Which direction?
SRAS shifts left (higher production costs reduce quantity supplied at each price level).
How do LRAS and the production possibilities curve (PPC) relate conceptually?
Both illustrate maximum sustainable output capacity; LRAS vertical = full employment output, PPC shows maximum feasible combinations of goods.
Define the expenditure multiplier and state its qualitative effect when MPC > 0.
The multiplier > 1: a $1 change in autonomous spending leads to a greater-than-$1 change in aggregate demand and real GDP.
How do income taxes act as automatic stabilizers during an expansion?
Tax revenues rise automatically as GDP rises, which dampens consumption and cools the expansion.
How does a decrease in the domestic price level affect net exports and therefore aggregate demand? Explain the mechanism.
A lower domestic price level makes domestic goods relatively cheaper for foreigners, increasing exports and net exports, which increases AD.
Explain why SRAS is upward sloping when nominal wages are fixed by contracts. Use real-wage/profit logic.
If price level rises while nominal wages are fixed, real wages fall, increasing firms’ profits and incentivizing more production; conversely, price falls reduce profits and output.
If a country opens borders to free movement of workers, how would LRAS and PPC shift? Explain.
Both shift right (increase in labor expands productive capacity and potential output).
With MPC = 0.8, calculate the multiplier and the maximum GDP change from a $10 billion change in government spending.
Multiplier = 1/(1−0.8)=5; change = 5 × $10B = $50B.
During a recession, do automatic stabilizers shift AD or SRAS? What is the short-run effect on AD and output?
They shift AD right (support demand) — e.g., higher transfer payments and lower taxes raise disposable income and increase AD, cushioning the fall in output.
The government of Euroland increases government spending. Describe precisely how AD changes (movement vs. shift) and explain why.
AD shifts right (increase in autonomous government spending increases total planned expenditures at each price level).
A major input price (energy) rises significantly. Describe the short-run effect on SRAS, price level, and unemployment.
SRAS shifts left (higher production costs), price level rises (cost-push inflation), and real output falls so unemployment increases (actual > natural rate).
Explain why in the long run there is no trade-off between inflation and unemployment and how price/wage flexibility produces a vertical LRAS.
In the long run wages and prices adjust fully; nominal wages rise/fall restoring real wages and bringing output back to potential—so unemployment returns to natural rate; LRAS vertical.
Olympia government wants to slow inflation. If MPC = 0.8, which policy and numeric effect will reduce real GDP by up to $50 billion? Evaluate options: increase taxes by $10B, decrease spending, etc.
Increasing taxes by $10B reduces disposable income; tax multiplier = -MPC/(1−MPC) = -0.8/0.2 = -4 → GDP change = -4 × $10B = -$40B. Increasing government spending by $10B increases GDP by $50B (spending multiplier = 5). So the policy that decreases GDP by up to $50B is decreasing government spending by $10B (change = -$50B). Correct answer: decreasing government spending by $10B decreases real GDP by a maximum of $50B.
Explain why automatic stabilizers do not require discretionary policy and how they affect the multiplier process.
They operate via existing tax/transfer rules that change with income automatically, reducing the size of swings (dampen the multiplier because net changes in autonomous spending are smaller).
Using an MPC of 0.75, calculate the maximum change in real GDP from a $100 billion increase in government spending. Show the multiplier and result.
Multiplier = 1 / (1 - MPC)
= 1 / (1 - 0.75) = 4.
Change in GDP = 4 × $100 billion = $400 billion.
Distinguish between a movement along SRAS vs. a shift of SRAS with specific examples (include demand shock and supply shock).
Movement along SRAS occurs when AD changes price level (e.g., AD shifts right → movement up SRAS). SRAS shifts when production costs change (e.g., input price increase shifts SRAS left).
An economy is above full employment in the short run. Describe the long-run adjustment process (nominal wages, SRAS, price level, output).
High demand raises wages over time; nominal wages increase → SRAS shifts left until output returns to LRAS (full employment), price level higher.
Distinguish the effects of a tax cut vs. an equal-sized increase in government spending on aggregate demand using multipliers and marginal propensity to consume.
Government spending has a direct effect equal to the spending times the spending multiplier. A tax cut's effect equals the tax change times the marginal propensity to consume and then the multiplier (tax multiplier magnitude = MPC/(1−MPC)). For given MPC, a direct spending increase typically has a larger immediate impact on AD than an equal-sized tax cut.
Evaluate the claim: "Automatic stabilizers fully eliminate the need for discretionary fiscal policy in a deep recession." Provide an AP-macro level explanation.
Incorrect. Automatic stabilizers cushion shocks but may be insufficient to restore full employment quickly in a deep recession; discretionary policy (large, targeted spending or tax changes) may still be necessary because stabilizers are gradual and limited by program size and fiscal constraints.