Chapter 29 AS-AD and the Business Cycle 29.1 Business-Cycle Definitions and Facts 1) What is a business cycle? What are its phases and turning points? Answer: A business cycle is the periodic but irregular up-and-down movement in production and jobs. It has two phases and two turning points. As the economy slows and the growth in real GDP turns negative, the economy enters the recession phase of the business cycle. At the bottom of the recession phase is one turning point, the trough. As the economy moves through the trough, it enters the expansion part of the business cycle during which real GDP grows. Finally, as the economy reaches its high point and swings from an expansion to a recession, the economy passes through the other turning point, the peak. Topic: Business cycle Skill: Level 1: Definition Objective: Checkpoint 29.1 Author: AA 2) What is the NBER's definition of recession? Discuss the relationship between the phases of the business cycle, real GDP and unemployment in the context of the United States economy from 1992 to the present. Answer: The NBER defines a recession as a period of significant decline in total output, income, employment, and trade, usually lasting at least six months to a year, and marked by widespread contractions in many sectors of the economy. From 1992 to until March, 2001, the economy was in an expansion. Then, the last U.S. recession started in March, 2001 and ended at the trough in November, 2001. During the expansion that ended in 2001, real GDP rose above potential GDP and unemployment generally fell to low levels. In the recession, real GDP fell below potential real GDP and unemployment rose so that it was greater than the natural rate of unemployment. After the recession ended in November, 2001 real GDP grew and the unemployment rate fell, though the growth in real GDP and the fall in unemployment were both slow. Topic: Business cycle Skill: Level 2: Using definitions Objective: Checkpoint 29.1 Author: CT 534 Bade/Parkin œ Foundations of Economics, Third Edition 3) When total output, income, employment, and trade decline for 6 to 12 months, the economy is in what part of the business cycle? Answer: When these real variables decline, the economy is in the recession phase of the business cycle. Topic: Business cycle Skill: Level 2: Using definitions Objective: Checkpoint 29.1 Author: MR 4) How does the average length of economic expansions and economic recessions in the United States in the last half of the twentieth century compare with the average length during other periods of U.S. history? Answer: The average length of expansions in the last half of the twentieth century has been much longer than at any other time in U.S. history. Correspondingly, the average length of recessions in the last half of the twentieth century has been much shorter than at any other time in U.S. history. Topic: Business cycle Skill: Level 1: Definition Objective: Checkpoint 29.1 Author: AA 29.2 Aggregate Supply 1) Name the four factors of production that determine the quantity of real GDP supplied. Which one fluctuates the most over the course of the business cycle? Answer: The factors are the quantity of labor employed, the quantities of capital and human capital and the technologies they employ, the quantities of land and natural resources, and the amount of entrepreneurial talent available. Over the course of a business cycle, the quantity of labor employed fluctuates the most. Topic: Aggregate supply Skill: Level 1: Definition Objective: Checkpoint 29.2 Author: NAU 2) What factor changes the quantity of real GDP supplied and results in a movement along the AS curve? Answer: Changes in the price level change the quantity of real GDP supplied and result in a movement along the AS curve. Topic: Aggregate supply, price level Skill: Level 1: Definition Objective: Checkpoint 29.2 Author: TPS Chapter 29 AS-AD and the Business Cycle 535 3) Does a rise in the price level bring a movement along the aggregate supply curve or does it shift the aggregate supply curve? Answer: A rise in the price level results in an upward movement along the aggregate supply curve. It does not shift the aggregate supply curve. Topic: Aggregate supply, price level Skill: Level 1: Definition Objective: Checkpoint 29.2 Author: DMC 4) If the money wage rate is constant and the price level increases, what happens to the real wage rate, firms' profits, and the aggregate quantity supplied? Answer: The real wage rate falls. Because the price level has increased and money wage rates are constant while real wage rates are lower, firms' profits increase. As a result, the aggregate quantity of goods and services supplied increases. Topic: Aggregate supply, price level Skill: Level 3: Using models Objective: Checkpoint 29.2 Author: WM 5) List three changes that lead to a shift of the aggregate supply curve. Discuss why each change shifts the aggregate supply curve and in which direction the curve shifts. Answer: A change in potential GDP, a change in the money wage rate, and a change in the money prices of other resources shift the aggregate supply curve. If potential GDP increases (decreases) or the money wage rate decreases (increases) or the money prices of other resources decrease (increase), aggregate supply increases (decreases) and the AS curve shifts rightward (leftward). Topic: Changes in aggregate supply Skill: Level 2: Using definitions Objective: Checkpoint 29.2 Author: CT 6) How does a fall in the money wage rate affect the aggregate supply curve? Answer: A fall in the money wage rate lowers firms' costs and shifts the aggregate supply curve rightward. Topic: Changes in aggregate supply, money wage rate Skill: Level 2: Using definitions Objective: Checkpoint 29.2 Author: DMC 536 Bade/Parkin œ Foundations of Economics, Third Edition 7) Give examples of factors that decrease aggregate supply. Which way does the AS curve shift? Answer: Aggregate supply decreases if potential GDP decreases. A rise in the money wage rate or the money price of other resources such as the price of oil raises firms' costs and decreases aggregate supply. The AS curve shifts leftward. Topic: Aggregate supply curve Skill: Level 2: Using definitions Objective: Checkpoint 29.2 Author: TPS 8) What is the effect on aggregate supply and potential GDP of an increase in the money wage rate? Answer: An increase in the money wage rate decreases aggregate supply and shifts the aggregate supply curve leftward. It has no effect on potential GDP. Topic: Changes in aggregate supply, money wage rate Skill: Level 2: Using definitions Objective: Checkpoint 29.2 Author: AA 9) "Moving along the AS curve, the real wage rate is constant while moving along the potential GDP line, the real wage rate changes." Explain whether the previous statement is correct or incorrect. Answer: The statement is incorrect. It reverses the situation. Moving along the AS curve, the money wage rate is constant and so the real wage rate changes. Moving along the potential GDP line, money wage rates have adjusted to the change in the price level and so the real wage rate is constant. Topic: Changes in aggregate supply, money wage rate Skill: Level 2: Using definitions Objective: Checkpoint 29.2 Author: MR Chapter 29 AS-AD and the Business Cycle 537 10) What can lead to the shift illustrated in the figure above? Answer: A decrease in the money wage rate or in the money prices of other resources, such as the price of oil, increase aggregate supply and shift the AS curve rightward while not changing potential GDP. Topic: Changes in aggregate supply, money wage rate Skill: Level 3: Using models Objective: Checkpoint 29.2 Author: MR 538 Bade/Parkin œ Foundations of Economics, Third Edition 11) In the above figure, illustrate the effect on the AS curve from an increase in the money price of a key resource such as oil. Answer: An increase in the money price of a key resource such as oil squeezes firms' profits and decreases aggregate supply. As illustrated in the figure above, the AS curve shifts leftward, in the figure from AS1 to AS2. Topic: Changes in aggregate supply, money prices of resources Skill: Level 3: Using models Objective: Checkpoint 29.2 Author: WM Chapter 29 AS-AD and the Business Cycle 539 29.3 Aggregate Demand 1) What is the effect on the aggregate demand curve from an increase in the price level? In particular, does the aggregate demand curve shift leftward or rightward? Answer: When the price level increases, there is a movement along the aggregate demand curve. The quantity of real GDP demanded decreases in response to an increase in the price level. However, the aggregate demand curve does not shift. Topic: Aggregate demand curve Skill: Level 2: Using definitions Objective: Checkpoint 29.3 Author: AA 2) How does an increase in the price level affect the aggregate quantity of goods and services demanded? Answer: An increase in the price level decreases the aggregate quantity of goods and services demanded for three reasons. First, it decreases the buying power of money. As a result, people decrease their demand for goods and services. Second, it raises the real interest rate. The real interest rate rises because an increase in the price level increases the demand for money, which raises the nominal interest rate, which, in the short run, raises the real interest rate. When the real interest rate rises, people and businesses delay plans for investment and purchases of big-ticket items. Finally, an increase in the price level makes domestically produced goods and services more expensive relative to foreign-produced goods and services.