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Chapter 19: Q5. (page 405)

An economy is producing at full employment when AD unexpectedly shifts to the left. A new classical economist would assume that as the economy adjusts back to producing at full employment, the price level will ________.

a. increase

b. decrease

c. stay the same

Short Answer

Expert verified

The correct option is (b): decrease.

Step by step solution

01

Explanation

The aggregate supply curve at full employment is vertical. When the AD shifts to the left, the output and price reduces. Assuming that the input prices are flexible, the nominal returns to the inputs will fall as the demand for inputs will fall. So, the AS will increase and shift to the right, where it produces the output again at the full employment level. However, the price level has been reduced in the process.

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Most popular questions from this chapter

Briefly describe the difference between a so-called real business cycle and a more traditional 鈥渟pending鈥� business cycle.

Suppose that the money supply and the nominal GDP for a hypothetical economy are \(96 billion and \)336 billion, respectively. What is the velocity of money? How will households and businesses react if the central bank reduces the money supply by $20 billion? By how much will nominal GDP have to fall to restore equilibrium, according to the monetarist perspective?

What is an efficiency wage? How might payment of an above-market wage reduce shirking by employees and reduce worker turnover? How might efficiency wages contribute to downward wage inflexibility, at least for a time, when aggregate demand declines?

Compare and contrast the market monetarist 5-percent target for nominal GDP growth with the older, simpler monetary rule advocated by Milton Friedman.

Place 鈥淢ON,鈥� 鈥淩ET,鈥� or 鈥淢AIN鈥� beside the statements that most closely reflect monetarist, rational expectations, or mainstream views, respectively:

a. Anticipated changes in aggregate demand affect only the price level; they have no effect on real output.

b. Downward wage inflexibility means that declines in aggregate demand can cause a long-lasting recession.

c. Changes in the money supply M increase PQ; at first only Q rises, because nominal wages are fixed, but once workers adapt their expectations to new realities, P rises and Q returns to its former level.

d. Fiscal and monetary policies smooth out the business cycle.

e. The Fed should increase the money supply at a fixed annual rate.
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