2 Check Understanding

Front 1

REPEAT 1. For each event, explain whether planned investment spending or unplanned inventory investment will change and in what direction.
a. An unexpected increase in consumer spending.

Back 1

An unexpected increase in consumer spending will result in a reduction in inventories as producers sell items from their inventories to satisfy this short-term increase in demand. This is negative unplanned inventory investment: it reduces the value of producers’ inventories.

Front 2

For each event, explain whether planned investment spending or unplanned inventory investment will change and in what direction.
b. A sharp rise in the cost of business borrowing.

Back 2

A rise in the cost of borrowing is equivalent to a rise in the interest rate: fewer investment spending projects are now profitable to producers, whether they are financed through borrowing or retained earnings. As a result, producers will reduce the amount of planned investment spending.

Front 3

For each event, explain whether planned investment spending or unplanned inventory investment will change and in what direction.
c. A sharp increase in the economy’ s growth rate of real GDP .

Back 3

A sharp increase in the rate of real GDP growth leads to a higher level of planned investment spending by producers, according to the accelerator principle, as they increase production capacity to meet higher demand.

Front 4

For each event, explain whether planned investment spending or unplanned inventory investment will change and in what direction.
d. An unanticipated fall in sales.

Back 4

As sales fall, producers sell less, and their inventories grow. This leads to positive unplanned inventory investment.

Front 5

2. Although economists believe that recessions typically begin as slumps in investment spending, they also believe that consumer spending eventually slumps during a recession. Explain why.

Back 5

A slump in planned investment spending will lead to a fall in real GDP in response to an unanticipated increase in inventories. The fall in real GDP will translate into a fall in households’ disposable income, and households will respond by reducing consumer spending. The decrease in consumer spending leads producers to further decrease output, further lowering disposable income and leading to further reductions in consumer spending. So although the slump originated in investment spending, it will cause a reduction in consumer spending.

Front 6

REPEAT 3. Determine the effect on aggregate demand of each of the following events. Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward.
a. A rise in the interest rate caused by a change in monetary policy.

Back 6

This is a shift of the aggregate demand curve. A decrease in the quantity of money raises the interest rate, since people now want to borrow more and lend less. A higher interest rate reduces investment and consumer spending at any given aggregate price level. So the aggregate demand curve shifts to the left.

Front 7

Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward.
b. A fall in the real value of money in the economy due to a higher aggregate price level.

Back 7

This is a movement up along the aggregate demand curve. As the aggregate price level rises, the real value of money holdings falls. This is the interest rate effect of a change in the aggregate price level: as the value of money falls, people want to hold more money. They do so by borrowing more and lending less. This leads to a rise in the interest rate and a reduction in consumer and investment spending. So it is a movement along the aggregate demand curve.

Front 8

Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward.
c. News of a worse-than-expected job market next year.

Back 8

This is a shift of the aggregate demand curve. Expectations of a poor job market, and so lower average disposable incomes, will reduce people’s consumer spending today at any given aggregate price level. So the aggregate demand curve shifts to the left.

Front 9

Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward.
d. A fall in tax rates

Back 9

This is a shift of the aggregate demand curve. A fall in tax rates raises people’s disposable income. At any given aggregate price level, consumer spending is now higher. So the aggregate demand curve shifts to the right.

Front 10

Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward.
e. A rise in the real value of assets in the economy due to a lower aggregate price level

Back 10

This is a movement down along the aggregate demand curve. As the aggregate price level falls, the real value of assets rises. This is the wealth effect of a change in the aggregate price level: as the value of assets rises, people will increase their consumption plans. This leads to higher consumer spending. So it is a movement along the aggregate demand curve.

Front 11

Explain whether it represents a movement along the aggregate demand curve (up or down) or a shift of the curve (leftward or rightward.
f. A rise in the real value of assets in the economy due to a surge in real estate values

Back 11

This is a shift of the aggregate demand curve. A rise in the real value of assets in the economy due to a surge in real estate values raises consumer spending at any given aggregate price level. So the aggregate demand curve shifts to the right.

Front 12

4. Determine the effect on short-run aggregate supply of each of the following events. Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve.
a. A rise in the consumer price index (CPI) leads producers to increase output.

Back 12

This represents a movement along the SRAS curve because the CPI—like the GDP deflator—is a measure of the aggregate price level, the overall price level of final goods and services in the economy.

Front 13

Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve.
b. A fall in the price of oil leads producers to increase output.

Back 13

This represents a shift of the SRAS curve because oil is a commodity. The SRAS curve will shift to the right because production costs are now lower, leading to a higher quantity of aggregate output supplied at any given aggregate price level.

Front 14

Explain whether it represents a movement along the SRAS curve or a shift of the SRAS curve.
c. A rise in legally mandated retirement benefits paid to workers leads producers to reduce output.

Back 14

This represents a shift of the SRAS curve because it involves a change in nominal wages. An increase in legally mandated benefits to workers is equivalent to an increase in nominal wages. As a result, the SRAS curve will shift leftward because production costs are now higher, leading to a lower quantity of aggregate output supplied at any given aggregate price level.

Front 15

REPEAT 5. In each of the following cases, determine whether the policy is an expansionary or contractionary fiscal policy. Explain your answer.
a. Several military bases around the country, which together employ tens of thousands of people, are closed.

Back 15

This is a contractionary fiscal policy because it is a reduction in government purchases of goods and services.

Front 16

determine whether the policy is an expansionary or contractionary fiscal policy. Explain your answer.
b. The number of weeks an unemployed person is eligible for unemployment benefits is increased.

Back 16

This is an expansionary fiscal policy because it is an increase in government transfers that will increase disposable income.

Front 17

determine whether the policy is an expansionary or contractionary fiscal policy. Explain your answer.
c. The federal tax on gasoline is increased.

Back 17

This is a contractionary fiscal policy because it is an increase in taxes that will reduce disposable income.

Front 18

6. Is the following statement true or false? Explain. “When the government expands, the private sector shrinks; when the government shrinks, the private sector expands.”

Back 18

This statement implies that expansionary fiscal policy will result in crowding out of the private sector, and that the opposite, contractionary fiscal policy, will lead the private sector to grow. Whether this statement is true or not depends upon whether the economy is at full employment; it is only then that we should expect expansionary fiscal policy to lead to crowding out. If, instead, the economy has a recessionary gap, then we should expect instead that the private sector grows along with the fiscal expansion, and contracts along with a fiscal contraction.

Front 19

7. Suppose you hold a gift certificate, good for certain products at participating stores. Is this gift certificate money? Why or why not?

Back 19

The defining characteristic of money is its liquidity: how easily it can be used to purchase goods and services. Although a gift certificate can easily be used to purchase a very defined set of goods or services (the goods or services available at the store issuing the gift certificate), it cannot be used to purchase any other goods or services. A gift certificate is therefore not money, since it cannot easily be used to purchase all goods and services.

Front 20

8. Explain why a system of commodity-backed money uses resources more efficiently than a system of commodity money.

Back 20

Commodity-backed money uses resources more efficiently than simple commodity money, like gold and silver coins, because commodity-backed money ties up fewer valuable resources. Although a bank must keep some of the commodity—generally gold and silver—on hand, it only has to keep enough to satisfy demand for redemptions. It can then lend out the remaining gold and silver, which allows society to use these resources for other purposes, with no loss in the ability to achieve gains from trade.