Say's law, associated with the French economist Jean-Baptiste Say, holds that supply creates its own demand, because every sale generates income for workers, owners, and input suppliers that can be spent elsewhere. Demand creates its own supply is Keynes' law, which puts the emphasis on demand instead. Prices adjust to clear every market instantly is a claim about price flexibility, not a statement about total supply and total demand. Money growth determines the price level is a monetary idea unrelated to Say's law.
Category: Say's and Keynes' Laws
Question 2
What did Keynes argue caused the Great Depression and ordinary recessions?
A collapse in productive capacity
Insufficient total demand
✓
A sudden loss of technology
A sharp drop in the number of workers
Correct Answer
Insufficient total demand
Keynes argued that the economy's capacity to produce was largely intact during the Depression, so the downturn came from insufficient total demand, which left firms with little reason to produce. A collapse in productive capacity did not happen, since factories closed but the machinery and equipment still existed. A sudden loss of technology did not happen either, because the technologies of the 1920s were still available. A sharp drop in the number of workers is also wrong, since the number of potential workers changed little.
Category: Say's and Keynes' Laws
Question 3
Which expression gives aggregate demand in an economy?
C + I + G + M - X
C + I + G + X + M
C + I + G + X - M
✓
C + S + G + X - M
Correct Answer
C + I + G + X - M
Aggregate demand is consumption plus investment plus government spending plus net exports, where net exports are exports (X) minus imports (M). C + I + G + M - X reverses net exports, subtracting exports instead of imports. C + I + G + X + M adds imports, but imports are spending on foreign output and must be subtracted. C + S + G + X - M replaces investment with saving, which is not a category of spending.
Category: Aggregate Demand
Question 4
A higher price level erodes the buying power of household savings, so people spend less. Which reason for the downward slope of the AD curve does this describe?
The interest rate effect
The foreign price effect
The substitution effect
The wealth effect
✓
Correct Answer
The wealth effect
The wealth effect says a higher price level reduces the real value of savings, so households feel less wealthy and cut consumption. The interest rate effect works through higher interest rates reducing investment and borrowing for big purchases. The foreign price effect works through exports becoming relatively expensive and imports relatively cheap. The substitution effect explains why demand curves for individual goods slope down, not why the AD curve does.
Category: Aggregate Demand
Question 5
An economy has these schedules. At a price level of 100, aggregate demand is 520 and aggregate supply is 400. At 105, aggregate demand is 510 and aggregate supply is 450. At 110, aggregate demand is 500 and aggregate supply is 500. At 115, aggregate demand is 490 and aggregate supply is 540. What is equilibrium real GDP?
500
✓
510
450
540
Correct Answer
500
Equilibrium is where aggregate demand equals aggregate supply, which happens at a price level of 110 with real GDP of 500. The value 510 is aggregate demand at a price level of 105, where demand still exceeds supply. The value 450 is aggregate supply at that same price level of 105. The value 540 is aggregate supply at a price level of 115, where supply exceeds demand.
Category: AD/AS Equilibrium
Question 6
At a price level of 120, an economy's aggregate demand is 760 and its aggregate supply is 700. What does the AD/AS model predict?
Supply exceeds demand by 60, so the price level tends to fall
Demand exceeds supply by 60, so the price level tends to rise
✓
Demand exceeds supply by 60, so the price level tends to fall
Supply exceeds demand by 60, so the price level tends to rise
Correct Answer
Demand exceeds supply by 60, so the price level tends to rise
Aggregate demand of 760 minus aggregate supply of 700 leaves excess demand of 60, and that excess demand pushes the price level up toward equilibrium, where firms supply more and buyers demand less. Supply exceeds demand by 60, so the price level tends to fall reverses which side is larger. Demand exceeds supply by 60, so the price level tends to fall gets the gap right but the direction of price pressure wrong. Supply exceeds demand by 60, so the price level tends to rise gets both parts wrong.
Category: AD/AS Equilibrium
Question 7
When an economy produces exactly at potential GDP, what is its unemployment rate?
Zero, since every worker has a job
Whatever cyclical unemployment happens to be
The natural rate of unemployment
✓
The rate typical of a deep recession
Correct Answer
The natural rate of unemployment
Potential GDP is also called full-employment GDP, and at that output unemployment equals the natural rate, the baseline level that occurs year in and year out. Zero, since every worker has a job is wrong because some unemployment exists even at full employment, as people move between jobs and skills fail to match openings. Whatever cyclical unemployment happens to be is wrong because cyclical unemployment is low, not variable, when output is at potential. The rate typical of a deep recession describes output far below potential, not at it.
Category: Aggregate Supply
Question 8
Holding input prices such as wages fixed, why do firms produce more output when the price level of final goods rises?
Their labor costs fall
Interest rates on their loans fall
Their customers gain wealth
Each sale becomes more profitable
✓
Correct Answer
Each sale becomes more profitable
With input costs held constant, a higher price for output widens the gap between what firms earn and what they pay, so producing more becomes more profitable and the SRAS curve slopes upward. Their labor costs fall cannot be the reason, since wages are held fixed by assumption. Interest rates on their loans fall is wrong, because a higher price level tends to push interest rates up, and that is a demand-side effect anyway. Their customers gain wealth is wrong, because a higher price level reduces the real value of savings.
Category: Aggregate Supply
Question 9
If productivity rises while aggregate demand stays the same, what does the AD/AS model predict?
Higher real GDP and downward pressure on the price level
✓
Lower real GDP and a higher price level
Higher real GDP and a higher price level
Lower real GDP and a lower price level
Correct Answer
Higher real GDP and downward pressure on the price level
Productivity growth shifts aggregate supply to the right, so along an unchanged AD curve equilibrium moves to more output and a lower price level. Lower real GDP and a higher price level is the result of a leftward SRAS shift, such as a rise in input prices. Higher real GDP and a higher price level is the result of a rightward AD shift. Lower real GDP and a lower price level is the result of a leftward AD shift.
Category: Shifts in Aggregate Supply
Question 10
A sharp, economy-wide increase in the price of oil affects which curve, and in which direction?
SRAS shifts to the right
SRAS shifts to the left
✓
AD shifts to the right
LRAS shifts to the right
Correct Answer
SRAS shifts to the left
Oil is a key input across the economy, so a higher oil price raises costs and reduces the profit from producing at any given price level, shifting SRAS to the left and lowering output while raising the price level. SRAS shifts to the right is what a fall in oil prices would cause. AD shifts to the right describes higher spending, which a rise in input costs does not cause in the model. LRAS shifts to the right is wrong, since changes in input prices generally do not shift LRAS and higher costs would not expand potential output.
Category: Shifts in Aggregate Supply
Question 11
Which event would shift the aggregate demand curve to the left?
A decrease in the price of energy
A rise in productivity
A drop in business confidence that cuts investment
✓
A decline in the price level
Correct Answer
A drop in business confidence that cuts investment
Less optimistic firms invest less, and because investment is a component of aggregate demand, total spending falls at every price level and AD shifts left. A decrease in the price of energy lowers input costs and shifts SRAS to the right. A rise in productivity also shifts aggregate supply to the right. A decline in the price level causes a movement along the AD curve, not a shift of it.
Category: Shifts in Aggregate Demand
Question 12
A war leaves an economy with a permanently smaller labor force. How does this loss of workers affect aggregate supply?
Only SRAS shifts left
SRAS and LRAS both shift right
Only LRAS shifts right
SRAS and LRAS both shift left
✓
Correct Answer
SRAS and LRAS both shift left
Fewer available workers reduce both what firms produce at each price level and the economy's potential output, so SRAS and LRAS both shift to the left. Only SRAS shifts left fits a change in input prices, which leaves potential GDP alone, but losing workers lowers potential GDP too. SRAS and LRAS both shift right describes growth in labor or productivity, the opposite case. Only LRAS shifts right gets both the curves and the direction wrong.
Category: Shifts in Aggregate Supply
Question 13
Which change would shift the SRAS curve while leaving the LRAS curve unchanged?
An economy-wide rise in wages
✓
Faster productivity growth
A larger labor force
Improved production technology
Correct Answer
An economy-wide rise in wages
A change in input prices such as wages shifts SRAS, since it changes the profit from producing at each price level, but it generally does not change potential GDP, so LRAS stays put. Faster productivity growth raises potential GDP and shifts LRAS as well. A larger labor force adds to the economy's productive capacity and shifts LRAS. Improved production technology raises potential output and shifts LRAS too.
Category: Shifts in Aggregate Supply
Question 14
According to the AD/AS model, what happens when consumer confidence falls sharply?
Real GDP falls and the price level rises
Real GDP and the price level both fall
✓
Real GDP rises and the price level falls
Real GDP and the price level both rise
Correct Answer
Real GDP and the price level both fall
Lower confidence reduces consumption spending, shifting AD to the left, so equilibrium moves down along the SRAS curve to lower output and a lower price level. Real GDP falls and the price level rises is the pattern of a leftward SRAS shift, not an AD shift. Real GDP rises and the price level falls is the pattern of a rightward SRAS shift. Real GDP and the price level both rise is the pattern of a rightward AD shift, such as rising confidence.
Category: Shifts in Aggregate Demand
Question 15
If the Federal Reserve acts to raise interest rates, how does the AD/AS model predict aggregate demand will respond?
It shifts to the right
It becomes vertical
It shifts to the left
✓
It stays put while only SRAS shifts
Correct Answer
It shifts to the left
Higher interest rates discourage business investment and household borrowing for big-ticket items such as homes and cars, so total spending falls at every price level and AD shifts to the left. It shifts to the right is what lower interest rates would cause. It becomes vertical is wrong, because a change in interest rates moves the AD curve but does not change its basic downward slope. It stays put while only SRAS shifts is wrong, because monetary policy works on spending, which is the demand side.
Category: Shifts in Aggregate Demand
Question 16
In a deep recession, with output far below potential GDP, the government cuts income taxes. What does the AD/AS model predict?
The price level rises with little change in real GDP
Real GDP and the price level both fall
Potential GDP rises immediately
Real GDP rises with little change in the price level
✓
Correct Answer
Real GDP rises with little change in the price level
A tax cut raises consumption and shifts AD to the right, and because the economy is on the flat part of SRAS, the shift mainly raises output with only a muted rise in the price level. The price level rises with little change in real GDP is what happens when the economy is already near potential, on the steep part of SRAS. Real GDP and the price level both fall describes a leftward AD shift. Potential GDP rises immediately is wrong, since a tax cut shifts demand and does not instantly expand productive capacity.
Category: Shifts in Aggregate Demand
Question 17
On the flat, far-left portion of the SRAS curve, what does a rightward shift in aggregate demand mainly change?
Output and unemployment
✓
The price level
Potential GDP
The natural rate of unemployment
Correct Answer
Output and unemployment
In this Keynesian zone the economy has many idle workers and factories, so extra demand draws out more production with little change in prices, raising output and cutting unemployment. The price level changes little here, which is why inflation is not much of a concern in this zone. Potential GDP is set by labor, capital, technology, and institutions, not by a demand shift. The natural rate of unemployment is a baseline level that a shift in demand does not change.
Category: SRAS Zones
Question 18
When equilibrium lies on the near-vertical part of the SRAS curve, what does a rightward shift in aggregate demand mostly do?
Raises real GDP
Raises the price level
✓
Cuts cyclical unemployment sharply
Lowers the price level
Correct Answer
Raises the price level
In this neoclassical zone the economy is at or near potential GDP, so firms cannot expand output much and extra demand mainly pushes up prices. Raises real GDP is wrong because output is already close to its potential limit. Cuts cyclical unemployment sharply is wrong because cyclical unemployment is already low near potential GDP. Lowers the price level gets the direction wrong, since more demand adds upward pressure on prices.
Category: SRAS Zones
Question 19
In the intermediate zone of the SRAS curve, how do unemployment and the price level respond to a leftward shift in aggregate demand?
Unemployment falls and the price level rises
Unemployment and the price level both rise
Unemployment rises and the price level falls
✓
Unemployment and the price level both fall
Correct Answer
Unemployment rises and the price level falls
In the intermediate zone a leftward AD shift moves output further below potential, raising unemployment, while it also lowers the price level, so unemployment and inflation pressure move in opposite directions. Unemployment falls and the price level rises is the result of a rightward AD shift in this zone. Unemployment and the price level both rise is the pattern of a leftward SRAS shift, not an AD shift. Unemployment and the price level both fall would need output to rise while prices fall, as with a rightward SRAS shift.
Category: SRAS Zones
Question 20
What does the vertical axis of an AD/AS diagram measure?
The price of one particular good
The interest rate on loans
The rate of unemployment
The overall price level, such as a price index
✓
Correct Answer
The overall price level, such as a price index
The AD/AS diagram plots the overall price level, measured with an index such as the GDP deflator or the CPI, against real GDP on the horizontal axis. The price of one particular good belongs on a supply and demand diagram for a single market. The interest rate on loans is the price measured in financial market diagrams, not here. The rate of unemployment is not plotted on either axis, although it can be inferred from how far output is from potential GDP.
Category: AD/AS Equilibrium