ECO2013.791 Principles of Macroeconomics Summer

ECO2013.791 Principles of Macroeconomics Summer A 2020 Xiaomin Guo, Ph.D., CFP®
Study Guide 8
1. List five factors that might cause the AD curve to shift outward.
2. What factors shift the short-run aggregate supply (SAS) curve? Explain the impact of changes
in each factor on the SAS curve.
3. Canada is the largest trading partner of the U.S. Suppose the U.S. economy keeps growing.
What will happen to the AD curve for Canada?
4. Give two examples of expectations that would tend to cause the aggregate demand curve to
rise (shift out to the right).
5. Below is a screenshot of Yahoo! Finance currency market. The last price of GBP/USD is
1.3151 and it changed by -0.008. Based on this information, which currency is appreciating?
Which one is appreciating? How will it influence the international trade between UK and US?
6. Why is the LAS curve vertical?
7. If an economy is in short-run equilibrium that is below potential, what forces will bring the
economy to long-run equilibrium automatically without government’s interference?
8. Demonstrate graphically and explain verbally a recessionary gap. Describe two solutions for
closing the gap.
9. Demonstrate graphically and explain verbally the case of an inflationary gap. Describe the
forces in the economy that will result in the gap closing itself.
ECO2013.791 Principles of Macroeconomics Summer A 2020 Xiaomin Guo, Ph.D., CFP®
Answer 1:
Factors that might cause the AD curve to shift outward are: (Any five of the following)
1. A rise in foreign income
2. A fall in the exchange rate
3. Expectations of rapid growth in the future AD.
4. Expectations of higher future prices
5. More equal distribution of income
6. Expansionary fiscal policy
7. Expansionary monetary policy.
Answer 2:
(a) Input prices. A rise (decline) in input prices shifts the SAS curve to the left (right).
(b) Changes in expectation of inflation. Expectation of higher (lower) future prices shifts the
SAS curve to the left (right).
(c) Excise and sales taxes. Higher (lower) excise or sales taxes shifts the SAS curve to the left
(d) Productivity. Higher (lower) workers’ productivity schedules shifts the SAS curve to the right
(e) Import prices. Higher (lower) import prices shifts the SAS curve to the right (left).
Answer 3:
As the U.S. economy keeps growing people in the U.S. will buy more things from Canada. This
will result in a rightward shift (an increase) in the Canadian AD curve.
Answer 4:
If there are expectations of rising incomes, consumers will be more confident about spending
their current incomes rather than saving for the future, increasing consumption expenditures. At
the same time, business will want to be prepared to meet the demands of a higher income
consumer segment, and will spend more on investment to increase output capacity.
Expectations of rising prices can also increase aggregate expenditures. If consumers believe that
prices will be higher in the future, it makes sense for them to accelerate some planned purchases
and buy them now, when they are cheaper. This was described as the intertemporal price level
Answer 5:
GBP/USD=1.1351, 1 GBP = 1.1351 USD initially.
As the price of GBP/USD is decreasing, GBP is becoming cheaper and depreciating. USD is
As GBP is depreciating, US will consider UK products cheaper thus buying more from UK. On
the contrary, US products to UK are becoming more expensive and UK will buy less from US.
In summary, US exports to UK will decrease, while imports from UK will increase.
Answer 6:
The LAS curve is vertical because potential output depends on the capacity for production, not
the price level. In the long run, output is independent of the price level.
ECO2013.791 Principles of Macroeconomics Summer A 2020 Xiaomin Guo, Ph.D., CFP®
Answer 7:
If the economy is in short-run equilibrium below potential output, underutilization of inputs will
cause input prices to fall, causing the short-run aggregate supply curve to shift down and the
price level to fall and thereby bringing the economy into long-run equilibrium at potential output.
Answer 8:
The diagram below shows a recessionary gap of (Y0 – Y1). The economy is in a short-run
equilibrium at point A with price level P0 and real output level Y1. A recessionary gap exists
when equilibrium output is below potential output as it is in the diagram.
Two potential solutions for closing the recessionary gap of (Y0 – Y1) are illustrated in Diagrams
A and B above. Diagram A illustrates how the gap can be closed by allowing the economy to fix
itself. Diagram B shows how the gap can be closed by an activist government policy.
Diagram A: Allowing the economy to solve the problem on its own means waiting for the excess
ECO2013.791 Principles of Macroeconomics Summer A 2020 Xiaomin Guo, Ph.D., CFP®
supply of factors of production to result in a fall in costs and wages. When cost and wages fall
the SAS curve will shift down from SAS0 to SAS1 and will intersect AD at point B. Point B
represents a new equilibrium with a lower price level of P1 (P1 < P0) and an increased real output
level of Y0 (Y0 > Y1). Since at point B our equilibrium output level is the potential output level
we no longer have a recessionary gap.
Diagram B: If the government gets actively involved and increases spending this results in an
increase in AD from AD0 to AD1. The result is a new equilibrium at point B. At point B the price
level has increased (from P0 to P1) but real output has increased from Y1 to Y0 and the
recessionary gap has been closed.
Answer 9:
Initially we are at point A with a price level of P0 and real output level of Y0. An inflationary gap
of (Y0 – Y1) exists because our current equilibrium level (Y1) is greater than the potential output
level (Y0). When this occurs the economy is straining its resources. To be able to produce beyond
the potential output level workers must work overtime and firms get extra workers by bidding
them away from other companies. The result is higher wages and increased costs for firms. The
increase in wages and costs results in the SAS curve shifting up from SAS0 to SAS1. The
economy moves to a new equilibrium point B. At point B the price level has risen to P1 (P1 > P0)
and real output has declined to the potential output level Y1. As a result we no longer have an
inflationary gap.

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