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Economic Environment
Course book
Prof Ashok Thomas

IIM Kozhikode
Fiscal Policy
Session 1: Fiscal policy
Introduction
Throughout this module, you will visit Econoland, a place created to illustrate macroeconomic
challenge concepts. You will learn from the experiences of the people in Econoland. Enjoy
your visit!
There are primarily two ways to influence our economy on a national level. One is called
monetary policy and will be covered in another unit. The other is through the government’s
power to tax and to spend. This is called fiscal policy.
In this unit, you will learn how changes in taxes and in government purchases affect the three
goals that all economies pursue: stable prices, high employment, and economic growth.
You will also learn how our income tax code is designed to automatically implement some of
the elements of fiscal policy. This is called the “automatic stabilizing effect” of our progressive
income tax, known as our national safety net.
Prior Knowledge
Before starting this unit, you should be familiar with the following:
• aggregate demand and real GDP
• Classical and Keynesian theories of economic activity
• the impact of autonomous spending changes on AD and nominal GDP
• the AD/AS model
• the unemployment gap (Contractionary gap) and the inflationary gap
• the inverse relationship between interest rates and investment

Practical Application
Government spending and taxing policies have an impact on the national economy. In the most
recent case, the Great Recession, the U.S. government used both changes in government
purchases and taxes to encourage economic activity in an attempt to shorten and soften the
impact of the recession.
Changes in government spending have a stronger, more predictable, and more immediate
impact on AD and the overall economy than tax changes. A balanced budget on the part of
government does NOT have a neutral impact on the economy. Other factors can reduce the
impact of the government fiscal policies and may even cause the policies to have the opposite
effect of their original intent.
During the recent Great Recession, expansionary fiscal policy was complemented by
expansionary monetary policy. Some economists credit this coordinated effort with a shorter,
less severe recession in the U.S. compared to the European Union and other countries around
the world.
Learning objectives
You will understand and be able to calculate the maximum impact on AD and nominal GDP
of a given change in government purchases and/or taxes.
You will understand and be able to calculate the maximum impact on AD and nominal GDP
of balanced budget proposals.
You will know the difference between budget surpluses and budget deficits as well as the
difference between debt and deficit.
You will be able to take into consideration other factors such as “crowding out”, time lags, and
the net export effect of these fiscal policy actions.
Activity 1
A) Consider the economy in the AS/AD model from Activity 1 (recessionary output). If the
government wanted to use the tool of government purchasing, would fiscal policy advisors
recommend the government increase or decrease government purchasing? Explain how this
action would affect AD, PL, and output. Use the model above to illustrate the change.
B) Consider the economy in the AS/AD model from Activity 1. If the government were to
change taxes, would fiscal policy advisors recommend the government raise or lower taxes?
Explain how this action would affect AD, PL, and Output.
C) Consider the economy in the AS/AD model from Activity 1. If the government were to
change transfer payments, would fiscal policy advisors recommend that the government
increase or decrease transfer payments? Explain how this action would affect AD, PL, and
output.
Question1) Econoland is in short-run equilibrium with output below full employment. Which
of the following would be an appropriate fiscal policy to increase output and decrease
unemployment?
A. decrease interest rates and expand the money supply

B. decrease taxes and decrease government purchases
C. increase government purchases and decrease taxes
D. increase interest rates and sell bonds
E. increase transfer payments and decrease interest rates
Question 2) Econoland is experiencing high inflation rates. What fiscal policy would be
appropriate to address the inflationary gap?
A. increase government transfer payments and decrease taxes

B. increase the money supply and decrease taxes
C. increase government purchases and decrease taxes
D. increase government purchases and increase taxes
E. decrease government purchases and increase taxes
Question3) Under which of the following circumstances would expansionary fiscal policy be
most effective?
A. high unemployment and low inflation

B. high unemployment and high inflation
C. low unemployment and high inflation
D. low unemployment and low inflation
Question 4) If the economy was in a severe recession, the most expansionary fiscal policy
would be to:
A. decrease both personal income taxes and government spending by equal amounts.
B. decrease both the reserve requirement and government spending by the same
proportion.
C. decrease personal income taxes and increase government spending by equal amounts.
D. increase the money supply and increase government spending by the same proportion.
E. increase social security taxes and increase government spending by equal amounts.
Question 5) In an econmy at full employment, a presidential candidate proposes cutting the

government debt in half in four years by increasing income tax rates and reducing
government expenditures. According to Keynesian theory, implementation of these policies is
most likely to increase:
A. consumer prices.
B. unemployment.
C. aggregate demand.
D. aggregate supply.
E. the rate of economic growth.
Multiplier effect
In this learning cycle, you will learn that increases in government spending, decreases in
taxes, or increases in transfer payments have a multiplied effect on aggregate demand and
GDP.
You will explore the multiplier effects and learn the three important multipliers:
• Spending Multiplier
• Tax Multiplier
• Balanced Budget Multiplier
You will be able to determine the minimum fiscal policy action necessary to close a
recessionary gap when the economy is below full employment. In addition, you will be able
to determine the necessary fiscal policy action to close an inflationary gap when the economy
is beyond full employment.
Activity 1
Imagine that you are a macroeconomic policy advisor to the president of Econoland.
You are asked about the future impact that a road and bridge repair project -- requiring 100
billion dollars in government spending -- could have on the economy
The government of Econoland decides to spend 100 billion dollars on road and bridge repair.
What is the initial impact to aggregate demand?
If the Marginal Propensity to Consume (MPC) equals .75, what is the maximum potential
impact of the spending on road and bridge repair on Output and RGDP?
Activity 2
Econoland is experiencing unemployment greater than the natural rate: the economy is
producing $200 billion below full employment. The MPC=.80. Assume that output is in the
horizontal segment, or Keynesian portion, of aggregate supply
a) Calculate the amount of government purchases (G) necessary to close the unemployment
gap. Is this an increase or a decrease in G? increase or decrease
b) Calculate the amount of a tax change necessary to close the unemployment gap. Is this a
larger or smaller change in taxes than the change in G (in question above)?
Larger or smaller
c) The government of Econoland decides to spend $10 billion on road repair. As a result,
equilibrium income rises by a total of $50 billion (without any crowding out). Based on this
information, calculate the marginal propensity to save (MPS) in Econoland.
d) If the marginal propensity to consume (MPC) in Econoland is 0.9, what is the maximum
amount that the equilibrium gross domestic product could change if government purchases
(G) increase by $1 billion?
Which of the following would increase the value of the spending multiplier?
A. an increase in government expenditure

B. an increase in exports
C. a decrease in government employment benefits
D. a decrease in the Marginal Propensity to Consume (MPC)
E. a decrease in the Marginal Propensity to Save (MPS)
e) The economy in Econoland is operating in the Classical range of the aggregate supply
curve. If the government increases transfer payments, what happens to aggregate demand,
output, and the price level?
AD (decreases increases or no change)
Output
Prices
f) If the government of Econoland raises taxes by $9 million to pay for $9 million in
increased government purchases, what is the impact on aggregate demand? Explain.
Activity 3
Question
If the government of Econoland raises taxes by $9 million to pay for $9 million in increased
government purchases, what is the impact on aggregate demand?
Government Spending has a greater impact on GDP than an equivalent change in taxes or
transfer payments.
The spending multiplier =1/MPS (Marginal to Propensity to Save)
When increasing government spending, the spending multiplier takes a positive value,
yielding an increase in aggregate demand.
When decreasing government spending, the spending multiplier takes a positive value,
yielding a decrease in aggregate demand.
The tax multiplier = - MPC/MPS or the spending multiplier -1.
When decreasing taxes, the tax multiplier takes a negative value, yielding an increase in
aggregate demand.
When increasing taxes, the tax multiplier takes a negative value, yielding a decrease in
aggregate demand.
The balanced budget multiplier =1 times the initial change in G.
A balanced budget still has an impact on GDP.
You can find the impact of a balanced budget by multiplying 1 times the initial change in
Government Purchases.
Question1) Which of the following would result in the largest increase in aggregate demand?
A. a $30 billion tax increase and a $30 billion increase in transfer payments
B. a $30 billion increase in military expenditure and a $30 billion decrease in personal
income taxes
C. a $30 billion increase in military expenditure and a $30 billion increase in personal
income taxes
D. a $30 billion tax cut and a $30 billion decrease in transfer payments
E. a $30 billion increase in social security payments and a $30 billion decrease in
military expenditures
Question 2) If a large increase in total spending has no effect on real gross domestic product,
it must be true that:
A. the price level is rising.

B. the economy is experiencing high unemployment.
C. the spending multiplier is equal to 1.
D. the economy is in short-run equilibrium.
E. aggregate supply has increased.
Question 3) Expansionary fiscal policy will be most effective when:
A. the economy is at or above full-employment output.

B. transfer payments are decreased while taxes remain unchanged.
C. wages and prices are flexible.
D. the Federal Reserve simultaneously increases the reserve requirement.
E. the aggregate supply curve is horizontal.
Question 4) Which of the following will result in the greatest increase in aggregate demand?
A. a $100 increase in taxes

B. a $100 decrease in taxes
C. a $100 increase in government expenditures
D. a $100 increase in government expenditures coupled with a $100 decrease in taxes
E. a $100 increase in government expenditures coupled with a $100 increase in taxes
Activity 3) Suppose the government spends $100 on construction materials.
A) State the numerical value of the initial impact of the increase in government spending on
aggregate demand?
B) You can use the spending multiplier = 1/(1–MPC). If the MPC = 0.75, what is the maximum
amount output could increase from this increase in government spending?
C) Suppose the government raises taxes by $600 million. If the MPC is .75, what is the initial
impact of the tax increase on aggregate demand? What is the maximum amount output could
decrease from this increase in taxes?
D) Suppose the government raises taxes by $600 million. If the MPC is .75, what is the initial
impact of the tax increase on aggregate demand? What is the maximum amount output could
decrease from this increase in taxes?
Course book
Short-Run Equilibrium and Long-

Run Equilibrium
Prof Ashok Thomas

IIM Kozhikode
Short run equilibrium
Introduction
challenge concepts. You will learn from the experiences of the people in Econoland. Enjoy your
visit!
This challenge concept examines how the economy moves to a short-run macroeconomic
equilibrium. In short-run equilibrium, aggregate demand is equal to short-run aggregate supply.
As a result, there is a predicted short-run real gross domestic product (GDP) and price level.
You will see that the short-run equilibrium GDP may be below full employment. In that case,
return to your earlier learning of Classical and Keynesian views of the economy to consider
how best to prompt the economy to a full-employment equilibrium.
In addition to illustrating the adjustments an economy makes in order to reach its short-run
macroeconomic equilibrium, the unit examines how the economy responds to shifts in the
aggregate demand and aggregate supply curves.
This challenge concept examines how the interaction between aggregate demand and aggregate
supply determine a short-run macroeconomic equilibrium. In addition, you will understand
how the economy adjusts in the short run to shifts in either the aggregate demand or aggregate
supply curves
Learning Objectives
You will be able to identify the short-run macroeconomic equilibrium and understand how the
economy adjusts to the short-run macroeconomic equilibrium.
Given a change in aggregate demand, you will be able to illustrate and describe how the
economy will change in response to the shift in the aggregate demand curve.
Similarly, you will be able to describe how the economy responds to shifts in the aggregate
supply curve.
As a foundation for understanding short-run macroeconomic adjustments, this unit examines

the nature of the short-run macroeconomic equilibrium and how the economy adjusts to that
equilibrium.
Question 1) An unintended decrease in inventories indicates:
a) the economy is in a short-run, but not a long-run, macroeconomic equilibrium.

b) the economy is in both a short-run and a long-run macroeconomic equilibrium.
c) the general price level is below the equilibrium general price level.
d) the quantity of aggregate output supplied is greater than the quantity of aggregate
output demanded.
e) the general price level must fall.
Explanation: An unintended decrease in inventories indicates that the quantity of aggregate

output demanded is greater than the quantity of aggregate output supplied. As a result, the
economy is not in a macroeconomic equilibrium and the general price level must be below the
equilibrium price level. Therefore, the general price level will rise toward equilibrium.
Question 2) A decrease in the general price level would cause:
a) a movement down and to the left along the aggregate supply curve.
b) a movement up and to the right along the aggregate supply curve.
c) a movement up and to the left along the aggregate demand curve.
d) a rightward shift in the aggregate supply curve.
e) a rightward shift in the aggregate demand curve.
Explanation: The aggregate supply curve describes a direct relationship between the general
price level and aggregate output. Therefore, a decrease in the general price level causes a
decrease in aggregate output leading to a movement down and to the left along the aggregate
supply curve.
Question 3) If the economy’s general price level is above the equilibrium price level:
a) Planned investment will increase.

b) The quantity of aggregate output demanded will be greater than the quantity of
aggregate output supplied.
c) The aggregate supply curve will shift left.
d) The aggregate demand curve will shift right.
e) There will be an undesired increase in inventories.
Explanation: If the economy's general price level is above the equilibrium price level, the
quantity of aggregate output supplied is greater than the quantity of aggregate output demanded
and there is an undesired increase in inventories.
Question 4) The intersection of the short-run aggregate supply and aggregate demand curves:
a) increases real household wealth.

b) occurs only if unemployment equals zero.
c) has a general price index of 100.
d) results in no undesired change in inventories.
e) results in the full employment level of real gross domestic product.
Explanation: The intersection of the short-run aggregate supply and aggregate demand curves
results in a short-run macroeconomic equilibrium. This equilibrium can occur at any level of
real gross domestic product, unemployment or general price level. The short-run
macroeconomic equilibrium requires that the quantity of aggregate output demanded equals
the quantity of aggregate output supplied; therefore, there is no undesired change in inventories.
Question 5) If an economy's general price level is below the equilibrium price level:
a) There will be an undesired decrease in inventories.

b) The aggregate supply curve will shift to the right.
c) Real household wealth will increase as the price level adjusts.
d) The aggregate demand curve will shift to the left.
e) Aggregate production will tend to decrease.
Explanation: When the economy’s general price level is below the equilibrium price level, the
quantity of aggregate output demanded will be greater than the quantity of aggregate output
supplied causing an undesired decrease in inventories. As a result, the general price level will
rise, decreasing household real wealth and causing a movement up and to the left along the
aggregate demand curve. Aggregate production increases as the economy moves up and to the
right along the aggregate supply curve.
Question 6) The short-run macroeconomic equilibrium requires:
a) full employment.
b) a balanced government budget.
c) the elimination of structural unemployment.
d) zero inventories.
e) no undesired investment into inventories.
Explanation: The short-run macroeconomic equilibrium requires the quantity of aggregate

output demanded equals the quantity of aggregate output supplied. Therefore, there is no
undesired investment into inventories.
Activity 1
Response OF economy’s short-run response to a shift in the aggregate demand curve.
During the period 1917 to 1919, Econoland experienced a severe demand shock due to a war.
In order to fight the war, Econoland's government spent a lot of money to purchase goods and
services. How did this increase in government expenditures affect Econoland's economy?
Draw the graph and answer the questions below:
What has happened to the price level in Econoland?
a) increased
b) decreased
c) remained the same
What has happened to the quantity of aggregate demanded at every price level?
a) increased
b) decreased
What has happened to the quantity of aggregate supply?
a) increased
b) decreased
Now what is the relationship between the quantity of aggregate supplied (QAS) and the
quantity of aggregate demanded (QAD)?
a) QAS > QAD

b) QAD > QAS
c) QAS = QAD
What has happened to the level of inventories in Econoland?
a) increased
b) decreased
Activity 2
During the period 1929 to 1933, Econoland's real gross domestic product fell from $103.1
billion to $71.6 billion. At the same time, unemployment rose from 3.2% to 24.9%. Finally,
from 1929 to 1933, Econoland's general price level fell from 100 to 78. What event would
explain these changes in Econoland's economy from 1929 to 1933?
Now it is your turn to practice. Show what would happen in Econoland if there was a decrease
in consumer confidence. Use the slider to illustrate this change. Based on how you
manipulated the graph above, answer the questions below:
What has happened initially to the price level in Econoland (just following the change in
aggregate demand)?
a) increased
b) decreased
a) increased
b) decreased
What has happened to the quantity of aggregate supply at each price level?
a) increased
b) decreased
Inititally, what is the relationship between the quantity of aggregate supplied (QAS) and the
a) QAS > QAD

b) QAD > QAS
c) QAS = QAD
a) increased
b) decreased
Although the short-run macroeconomic equilibrium changes when there is a shift in aggregate demand,
it is crucial to remember that the economy will quickly begin adjusting to the new short-run
macroeconomic equilibrium that exists where the new aggregate demand curve intersects aggregate
supply. For instance, following an increase in aggregate demand, initially there will be a shortage, price
levels will increase, and real output will increase. At the new short-run equilibrium there will be a higher
equilibrium price level and higher real GDP.
Multiple-Choice Questions
Question1) An increase in the general price level will:
a) cause a movement down and to the right along the aggregate demand curve.
b) cause a movement up and to the left on the aggregate demand curve.
c) shift the aggregate demand curve to the left.
d) shift the aggregate demand curve to the right.
e) affect only the aggregate supply curve.
Explanation: An increase in the general price level reduces real household wealth leading
to fewer household expenditures causing a decrease in the quantity of aggregate output
demanded; a movement up and to the left on the aggregate demand curve.
Question 2) A rightward shift in the aggregate demand curve could be caused by:
a) growing business optimism leading to an increase in planned investment.

b) undesired investment into inventories.
c) an increase in taxes.
d) a decrease in household consumption expenditures.
e) an increase in imports.
Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If the

government reduces its purchases of goods and services:
a) the equilibrium general price level will fall and equilibrium real gross domestic
product will fall.
b) the equilibrium general price level will rise and equilibrium real gross domestic
product will fall.
c) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
d) the equilibrium general price level will rise and equilibrium real gross domestic
product will rise.
e) there will be no change in the short-run macroeconomic equilibrium.
Explanation: When the government reduces its purchases of goods and services, aggregate
demand decreases shifting the aggregate demand curve to the left. This shift in aggregate
demand results in a new macroeconomic equilibrium that is at a lower general price level and
a lower level of real gross domestic product.
Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. If businesses

become more optimistic about the future and increase their level of planned investment:
a) the equilibrium general price level will rise and equilibrium real gross domestic
product will fall.
b) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
product will fall.
product will rise.
Explanation: When the businesses increase their level of planned investment, aggregate
demand increases shifting the aggregate demand curve to the right. This shift in aggregate
demand results in a new macroeconomic equilibrium.
Question 5) An economy is experiencing falling unemployment and rising prices. This could
be explained by:
a) an increase in aggregate supply.

b) a decrease in aggregate supply.
c) an increase in aggregate demand.
d) a decrease in aggregate demand.
e) both aggregate demand and aggregate supply decrease.
Explanation: An increase in aggregate demand causes a rightward shift in the aggregate

demand curve. This results in a new short-run macroeconomic equilibrium at a higher general
price level and higher level of real gross domestic product (lower unemployment).
Question 6) An economy is experiencing rising unemployment and deflation. This could be

explained by:
a) a leftward shift in the aggregate supply curve.

b) a leftward shift in the aggregate demand curve.
c) a rightward shift in the aggregate demand curve.
e) a rightward shift in both the aggregate demand and aggregate supply curves.
Explanation: A leftward shift in the aggregate demand curve represents a decrease in

aggregate demand. This results in a new short-run macroeconomic equilibrium at a lower
general price level (deflation) and lower level of real gross domestic product (higher
unemployment).
Short run equilibrium and aggregate supply shifts
The economy’s short-run response to a shift in the aggregate supply curve is examined in this
unit.
In the mid and late 1920s, Econoland experienced substantial increases in worker productivity. Assume
that the economy was producing below the full employment equilibrium. How did these productivity
improvements affect Econoland's economy in the short run? On the interactive graph below, use the
slider on the bottom to show the effect.
Activity 3
Based on your work on the graph above, consider the following questions:
i) Will the increase in worker productivity increase aggregate supply or aggregate demand?
ii) What caused the undesired buildup of inventories?
iii) Describe the effect of the increase in inventories on price level.
iv) Describe the effect of the change in price level on QAD and QAS as the economy returns
to a short-run equilibrium.
Activity 4
During the period 1973 to 1975, Econoland's real gross domestic product fell from $1,255
billion to $1,234 billion. At the same time, unemployment rose from 4.8% to 8.3%, and the
general price level rose from 106 to 126. What event would explain these changes in
Econoland's economy from 1973 to 1975?
On the interactive graph below, use the slider on the bottom to show the effect of this event.
i) If output has decreased and price level has increased, has there been a change in aggregate
supply or aggregate demand?
ii) What caused the undesired decrease of inventories?
iii) Describe the effect of the decrease in inventories on price level
Conclusion
Shifts in the aggregate supply curve lead to a new short-run macroeconomic equilibrium. As
the economy moves to the new equilibrium, it experiences changes in the general price level
and real gross domestic product. For instance, with an increase in aggregate supply (or shift to
the right), there will initially be excess supply of some goods and prices will fall. The new
short-run equilibrium will have a lower price level and an increased real GDP. When aggregate
supply shifts to the left there will be an increase in the price level and a decrease in output
accompanied by an increase in unemployment. This can be called stagflation or cost push
inflation.
Question 1) A decrease in the general price level will:
a) shift the aggregate supply curve to the left.

b) shift the aggregate supply curve to the right.
c) affect only the aggregate demand curve.
d) cause a movement up and to the right along the aggregate supply curve.
e) cause a movement down and to the left on the aggregate supply curve.
Explanation: A decrease in the general price level reduces overall business profits. In the
short-run, production costs tend to be “sticky.” Therefore, when the general price level falls,
economic profit tends to fall because profit per unit falls (lower prices and sticky costs).
Businesses reduce the overall level of production. This results in a movement down and to
the left along the aggregate supply curve.
Question 2) A leftward shift in the aggregate supply curve could be caused by:
a) an increase in worker productivity.

b) an increase in taxes.
c) a decrease in the price of oil.
d) rising nominal wages.
e) an increase in government purchases of goods and services.
Explanation: In the short run, a leftward shift in the aggregate supply curve could be caused
by an increase in nominal wages. An increase in worker productivity and decrease in the price
of oil would both increase aggregate supply shifting the curve to the right. An increase in taxes
would decrease aggregate demand, while an increase in government purchases of goods and
services would increase aggregate demand.
Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If there is a

general increase in nominal wages:
product will fall.
product will rise.
product will fall.
d) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
e) there will be no change in the short-run macroeconomic equilibrium
Explanation: An increase in nominal wages will decrease aggregate supply shifting the
aggregate supply curve to the left. This shift in aggregate supply results in a new
macroeconomic equilibrium that is at a higher general price level and a lower level of real
gross domestic product.
Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. A general

increase in labor productivity causes:
a) the equilibrium general price level to rise and equilibrium real gross domestic product
to rise.
b) the equilibrium general price level to rise and equilibrium real gross domestic product
to fall.
c) the equilibrium general price level to fall and equilibrium real gross domestic product
to rise.
d) the equilibrium general price level to fall and equilibrium real gross domestic product
to fall.
e) no change in the short-run macroeconomic equilibrium.
Explanation: A general increase in labor productivity increases aggregate supply shifting the
aggregate supply curve to the right. This shift in aggregate supply results in a new
macroeconomic equilibrium that is at a lower general price level and a higher level of real
gross domestic product.
Question 5) An economy is experiencing falling unemployment and deflation. This could be

explained by:
a) a decrease in aggregate supply.

b) an increase in aggregate supply.
Explanation: An increase in aggregate supply causes a rightward shift in the aggregate supply
curve. This results in a new short-run macroeconomic equilibrium at a lower general price level
(deflation) and higher level of real gross domestic product (lower unemployment).
Question 6) An economy is experiencing rising unemployment and inflation. This could be

explained by:
a) a leftward shift in the aggregate demand curve.
b) a leftward shift in the aggregate supply curve.
c) a rightward shift in the aggregate supply curve.
d) a rightward shift in the aggregate demand curve.
Explanation: A leftward shift in the aggregate supply curve represents a decrease in aggregate
supply. This results in a new short-run macroeconomic equilibrium at a higher general price
level (inflation) and lower level of real gross domestic product (higher unemployment).
Long-run equilibrium
Introduction
your visit!
You will see that, at any current time, the short-run equilibrium of the overall economy may
differ from the long-run equilibrium, or the capacity of the economy. Moreover, you will learn
how to apply both the Classical and Keynesian policy perspectives for the economy to move
towards a full-employment equilibrium.
The Classical view, as you recall, anticipates that if the economy is in short-run equilibrium
below full employment, then wages and prices will fall, employment will increase (with
unemployment decreasing), and the economy will move towards full-employment real GDP.
In contrast, with the Keynesian approach that assumes some downward rigidity in wages and
prices, discretionary fiscal and monetary policy to stimulate aggregate demand would move
the economy towards full-employment real GDP.
You will see how economists define the long-run equilibrium for an economy, in which there
is no cyclical unemployment. There will always be some frictional unemployment; that is,
individuals who are between jobs. Yet, when the economy is in this long-run equilibrium,
there is no need for a policy to either stimulate or contract the economy.
Prior to the Great Recession of 2007, most economists would agree that the United
States economy had been in a long-run equilibrium with little cyclical unemployment and
modest inflation for the preceding three years.
Learning Objectives
As a result of this unit, you will be able to compare and contrast the differing schools of
thought of how the economy moves back towards its long-run equilibrium.
Specifically, you will be able to utilize your knowledge of the Classical and Keynesian views
and to demonstrate both of these theories with the aggregate demand and aggregate supply
model.
Moving from a short-run to long-run equilibrium

Question 1) Which of the following would most likely cause the United States economy to
fall into a recession?
a) an increase in welfare payments

b) an increase in exports
c) a decrease in savings by consumers
d) a decrease in the required reserve ratio
e) a decrease in consumer spending
Question 2) Which of the following will most likely result from a decrease in government
spending?
a) an increase in output
b) an increase in the price level
c) an increase in employment
d) a decrease in aggregate demand
e) a decrease in aggregate supply
Question 3) An unanticipated decrease in aggregate demand when the economy is in

equilibrium will result in:
a) a decrease in real gross domestic product.
b) a decrease in voluntary unemployment.
c) a decrease in aggregate supply.
d) a decrease in the natural rate of unemployment.
e) a decrease in unplanned inventories.
Question 4) If businesses are experiencing an unplanned increase in inventories, which of the

following is most likely to be true?
a) The economy is growing and will continue to grow until a new equilibrium level of
spending is reached.
b) Aggregate demand is less than output, and the level of spending will decrease.
c) Aggregate demand is greater than output, and the level of spending will increase.
d) Planned investment is greater than planned saving, and the level of spending will
decrease.
e) Planned investment is less than planned saving, and the level of spending will
increase.
Question 5) Which of the following statements best describes the impact of a decrease in
Japanese income on aggregate demand in the United States?
a) Aggregate demand will decrease because demand for U.S. exports decreases.
b) Aggregate demand will decrease because the value of the U.S. dollar decreases
relative to the Japanese yen.
c) There will be no change in aggregate demand because U.S. aggregate demand
depends only on the income of U.S. consumers.
d) Aggregate demand will increase because a decrease in income in Japan causes an
increase in income in the U.S.
e) Aggregate demand will increase because interest rates in the U.S. decrease.
Adjustments in the long run
Activity 1
Based on the graph
A) Based on the graph above, the economy is in:
a) a recessionary gap.
b) an inflationary gap.
B) Which of the following policy responses would a Keynesian favor? Check all that apply:
a) increase taxes
b) increase government spending
c) increase interest rates
d) increase exchange rates
e) increase money supply
f) decrease taxes
g) decrease government spending
h) nominal wages falling
C) Based on the Keynesian response identified above, show the change on the graph.
D) Which change(s) would occur that a Classical economist would say are most effective for
bringing the economy back to its long run equilibrium?
a) increase taxes
f) decrease taxes
E) Based on the Classical response identified above, show the change on the graph.
Multiple- Choice Questions
Question 1) If an economy’s short-run aggregate supply curve is upward sloping, a Keynesian

would argue that an increase in government spending will most likely result in a decrease in
the:
a) real level of output.
b) price level.
c) unemployment rate.
d) interest rate.
e) government’s budget deficit.
Question 2) The classical economists argued that involuntary unemployment would be

eliminated by:
a) increasing government spending to increase aggregate demand.
b) increasing the money supply to stimulate investment spending.
c) maintaining the growth of the money supply at a constant rate.
d) self-correcting market forces stemming from flexible prices and wages.
e) decreasing corporate income taxes to encourage investment.
Question 3) Which of the following policies would a Keynesian recommend during a period
of high unemployment and low inflation?
a) decreasing taxes to stimulate aggregate demand
b) decreasing the money supply to reduce aggregate demand
c) decreasing government spending to stimulate aggregate supply
d) balancing the budget to stimulate aggregate supply
e) imposing wage and price controls to stimulate aggregate supply
Question 4) Suppose the economy of a country is currently in a recessionary gap. A classical

economist would argue that which of the following will occur?
a) Rising wages will shift the aggregate demand curve to the right, producing full
employment.
b) The economy will remain in its current equilibrium level of output because of sticky
wages.
c) Rising wages will shift the short-run aggregate supply curve to the right, producing
full employment.
d) Falling wages will shift the short-run aggregate supply curve to the right, producing
full employment.
e) Falling wages will shift the aggregate demand curve to the right, producing full
employment.
Question 5) An important assumption in Keynesian theory is that:
a) Price rigidity will cause downturns in the economy to self-correct.

b) Prices are sticky and decreases in aggregate demand will lead to an increase in
unemployment.
c) When aggregate demand is inadequate, prices will fall.
d) When interest rates are high, many businesses borrow money.
e) Changes in the money supply are the major cause of changes in real output and price
level.
Conclusion
A decrease in aggregate demand (for example, from a decrease in real wealth) will lead to a
lower level of real GDP and lower price level. The economy will be operating below full
employment, in a recession, with cyclical unemployment. As you know, there are two
responses to this concern: Classical and Keynesian.
With the Classical view, flexible wages and prices should result in lower wages and an increase
(outward or rightward shift) in the short-run aggregate supply curve, bringing the equilibrium
back towards full employment. Market forces, not government intervention, will bring the
economy back to full employment.
With the Keynesian view, wage rigidity or stickiness can result in continued and persistent
cyclical unemployment. Intervention in the form of expansionary fiscal or monetary policy is
needed to increase (a rightward shift) aggregate demand and increase real GDP, reducing
cyclical unemployment. In this case, the economy will return to its full employment GDP.
Course book
Short-Run Equilibrium and Long-

Run Equilibrium
Prof Ashok Thomas

IIM Kozhikode
Short run equilibrium
Introduction
visit!
This challenge concept examines how the economy moves to a short-run macroeconomic
equilibrium. In short-run equilibrium, aggregate demand is equal to short-run aggregate supply.
As a result, there is a predicted short-run real gross domestic product (GDP) and price level.
You will see that the short-run equilibrium GDP may be below full employment. In that case,
return to your earlier learning of Classical and Keynesian views of the economy to consider
how best to prompt the economy to a full-employment equilibrium.
In addition to illustrating the adjustments an economy makes in order to reach its short-run
macroeconomic equilibrium, the unit examines how the economy responds to shifts in the
aggregate demand and aggregate supply curves.
This challenge concept examines how the interaction between aggregate demand and aggregate
supply determine a short-run macroeconomic equilibrium. In addition, you will understand
how the economy adjusts in the short run to shifts in either the aggregate demand or aggregate
supply curves
Learning Objectives
You will be able to identify the short-run macroeconomic equilibrium and understand how the
economy adjusts to the short-run macroeconomic equilibrium.
Given a change in aggregate demand, you will be able to illustrate and describe how the
economy will change in response to the shift in the aggregate demand curve.
Similarly, you will be able to describe how the economy responds to shifts in the aggregate
supply curve.
As a foundation for understanding short-run macroeconomic adjustments, this unit examines

the nature of the short-run macroeconomic equilibrium and how the economy adjusts to that
equilibrium.
Question 1) An unintended decrease in inventories indicates:
a) the economy is in a short-run, but not a long-run, macroeconomic equilibrium.

b) the economy is in both a short-run and a long-run macroeconomic equilibrium.
c) the general price level is below the equilibrium general price level.
d) the quantity of aggregate output supplied is greater than the quantity of aggregate
output demanded.
e) the general price level must fall.
Question 2) A decrease in the general price level would cause:
a) a movement down and to the left along the aggregate supply curve.
b) a movement up and to the right along the aggregate supply curve.
c) a movement up and to the left along the aggregate demand curve.
e) a rightward shift in the aggregate demand curve.
Question 3) If the economy’s general price level is above the equilibrium price level:
a) Planned investment will increase.

b) The quantity of aggregate output demanded will be greater than the quantity of
aggregate output supplied.
c) The aggregate supply curve will shift left.
d) The aggregate demand curve will shift right.
e) There will be an undesired increase in inventories.
Question 4) The intersection of the short-run aggregate supply and aggregate demand curves:
a) increases real household wealth.

b) occurs only if unemployment equals zero.
c) has a general price index of 100.
d) results in no undesired change in inventories.
e) results in the full employment level of real gross domestic product.
Question 5) If an economy's general price level is below the equilibrium price level:
a) There will be an undesired decrease in inventories.

b) The aggregate supply curve will shift to the right.
c) Real household wealth will increase as the price level adjusts.
d) The aggregate demand curve will shift to the left.
e) Aggregate production will tend to decrease.
Question 6) The short-run macroeconomic equilibrium requires:

a) full employment.
b) a balanced government budget.
c) the elimination of structural unemployment.
d) zero inventories.
e) no undesired investment into inventories.
Activity 1
Response OF economy’s short-run response to a shift in the aggregate demand curve.
During the period 1917 to 1919, Econoland experienced a severe demand shock due to a war.
In order to fight the war, Econoland's government spent a lot of money to purchase goods and
services. How did this increase in government expenditures affect Econoland's economy?
Draw the graph and answer the questions below:
What has happened to the price level in Econoland?
a) increased
b) decreased
a) increased
b) decreased
What has happened to the quantity of aggregate supply?
a) increased
b) decreased
Now what is the relationship between the quantity of aggregate supplied (QAS) and the
a) QAS > QAD

b) QAD > QAS
c) QAS = QAD

a) increased
b) decreased
Activity 2
During the period 1929 to 1933, Econoland's real gross domestic product fell from $103.1
billion to $71.6 billion. At the same time, unemployment rose from 3.2% to 24.9%. Finally,
from 1929 to 1933, Econoland's general price level fell from 100 to 78. What event would
explain these changes in Econoland's economy from 1929 to 1933?
Now it is your turn to practice. Show what would happen in Econoland if there was a decrease
in consumer confidence. Use the slider to illustrate this change. Based on how you
manipulated the graph above, answer the questions below:
What has happened initially to the price level in Econoland (just following the change in
aggregate demand)?
a) increased
b) decreased
a) increased
b) decreased
What has happened to the quantity of aggregate supply at each price level?
a) increased
b) decreased
Inititally, what is the relationship between the quantity of aggregate supplied (QAS) and the
a) QAS > QAD

b) QAD > QAS
c) QAS = QAD

a) increased
b) decreased
Although the short-run macroeconomic equilibrium changes when there is a shift in aggregate demand,
it is crucial to remember that the economy will quickly begin adjusting to the new short-run
macroeconomic equilibrium that exists where the new aggregate demand curve intersects aggregate
supply. For instance, following an increase in aggregate demand, initially there will be a shortage, price
levels will increase, and real output will increase. At the new short-run equilibrium there will be a higher
equilibrium price level and higher real GDP.
Multiple-Choice Questions
Question1) An increase in the general price level will:
a) cause a movement down and to the right along the aggregate demand curve.
b) cause a movement up and to the left on the aggregate demand curve.
c) shift the aggregate demand curve to the left.
d) shift the aggregate demand curve to the right.
e) affect only the aggregate supply curve.
Question 2) A rightward shift in the aggregate demand curve could be caused by:
a) growing business optimism leading to an increase in planned investment.

b) undesired investment into inventories.
c) an increase in taxes.
d) a decrease in household consumption expenditures.
e) an increase in imports.
Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If the

government reduces its purchases of goods and services:
a) the equilibrium general price level will fall and equilibrium real gross domestic
product will fall.
product will fall.
product will rise.
product will rise.
Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. If businesses

become more optimistic about the future and increase their level of planned investment:
product will fall.
b) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
product will fall.
product will rise.
Question 5) An economy is experiencing falling unemployment and rising prices. This could
be explained by:
a) an increase in aggregate supply.

b) a decrease in aggregate supply.
Question 6) An economy is experiencing rising unemployment and deflation. This could be

explained by:
a) a leftward shift in the aggregate supply curve.

b) a leftward shift in the aggregate demand curve.
c) a rightward shift in the aggregate demand curve.
Short run equilibrium and aggregate supply shifts
The economy’s short-run response to a shift in the aggregate supply curve is examined in this
unit.
In the mid and late 1920s, Econoland experienced substantial increases in worker productivity. Assume
that the economy was producing below the full employment equilibrium. How did these productivity
improvements affect Econoland's economy in the short run? On the interactive graph below, use the
slider on the bottom to show the effect.
Activity 3
i) Will the increase in worker productivity increase aggregate supply or aggregate demand?
ii) What caused the undesired buildup of inventories?
iii) Describe the effect of the increase in inventories on price level

Activity 4
During the period 1973 to 1975, Econoland's real gross domestic product fell from $1,255
billion to $1,234 billion. At the same time, unemployment rose from 4.8% to 8.3%, and the
general price level rose from 106 to 126. What event would explain these changes in
Econoland's economy from 1973 to 1975?
On the interactive graph below, use the slider on the bottom to show the effect of this event.
i) If output has decreased and price level has increased, has there been a change in aggregate
supply or aggregate demand?
ii) What caused the undesired decrease of inventories?
iii) Describe the effect of the decrease in inventories on price level
Conclusion
Shifts in the aggregate supply curve lead to a new short-run macroeconomic equilibrium. As
the economy moves to the new equilibrium, it experiences changes in the general price level
and real gross domestic product. For instance, with an increase in aggregate supply (or shift to
the right), there will initially be excess supply of some goods and prices will fall. The new
short-run equilibrium will have a lower price level and an increased real GDP. When aggregate
supply shifts to the left there will be an increase in the price level and a decrease in output
accompanied by an increase in unemployment. This can be called stagflation or cost push
inflation.
Question 1) A decrease in the general price level will:
a) shift the aggregate supply curve to the left.

b) shift the aggregate supply curve to the right.
c) affect only the aggregate demand curve.
d) cause a movement up and to the right along the aggregate supply curve.
e) cause a movement down and to the left on the aggregate supply curve.
Question 2) A leftward shift in the aggregate supply curve could be caused by:
a) an increase in worker productivity.

b) an increase in taxes.
c) a decrease in the price of oil.
d) rising nominal wages.
e) an increase in government purchases of goods and services.
Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If there is a

general increase in nominal wages:
product will fall.
product will rise.
product will fall.
d) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
e) there will be no change in the short-run macroeconomic equilibrium
Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. A general

increase in labor productivity causes:
a) the equilibrium general price level to rise and equilibrium real gross domestic product
to rise.
b) the equilibrium general price level to rise and equilibrium real gross domestic product
to fall.
c) the equilibrium general price level to fall and equilibrium real gross domestic product
to rise.
d) the equilibrium general price level to fall and equilibrium real gross domestic product
to fall.
e) no change in the short-run macroeconomic equilibrium.
Question 5) An economy is experiencing falling unemployment and deflation. This could be

explained by:
a) a decrease in aggregate supply.

b) an increase in aggregate supply.
Question 6) An economy is experiencing rising unemployment and inflation. This could be

explained by:
a) a leftward shift in the aggregate demand curve.
b) a leftward shift in the aggregate supply curve.
c) a rightward shift in the aggregate supply curve.
d) a rightward shift in the aggregate demand curve.
Long-run equilibrium
Introduction
your visit!
You will see that, at any current time, the short-run equilibrium of the overall economy may
differ from the long-run equilibrium, or the capacity of the economy. Moreover, you will learn
how to apply both the Classical and Keynesian policy perspectives for the economy to move
towards a full-employment equilibrium.
The Classical view, as you recall, anticipates that if the economy is in short-run equilibrium
below full employment, then wages and prices will fall, employment will increase (with
unemployment decreasing), and the economy will move towards full-employment real GDP.
In contrast, with the Keynesian approach that assumes some downward rigidity in wages and
prices, discretionary fiscal and monetary policy to stimulate aggregate demand would move
the economy towards full-employment real GDP.
You will see how economists define the long-run equilibrium for an economy, in which there
is no cyclical unemployment. There will always be some frictional unemployment; that is,
individuals who are between jobs. Yet, when the economy is in this long-run equilibrium,
there is no need for a policy to either stimulate or contract the economy.
Prior to the Great Recession of 2007, most economists would agree that the United
States economy had been in a long-run equilibrium with little cyclical unemployment and
modest inflation for the preceding three years.
Learning Objectives
As a result of this unit, you will be able to compare and contrast the differing schools of
thought of how the economy moves back towards its long-run equilibrium.
Specifically, you will be able to utilize your knowledge of the Classical and Keynesian views
and to demonstrate both of these theories with the aggregate demand and aggregate supply
model.
Moving fromm a short run to short run equilibrium
Question 1) Which of the following would most likely cause the United States economy to
fall into a recession?
a) an increase in welfare payments
b) an increase in exports
c) a decrease in savings by consumers
d) a decrease in the required reserve ratio
e) a decrease in consumer spending
Question 2) Which of the following will most likely result from a decrease in government
spending?
a) an increase in output
b) an increase in the price level
c) an increase in employment
d) a decrease in aggregate demand
e) a decrease in aggregate supply
Question 3) An unanticipated decrease in aggregate demand when the economy is in

equilibrium will result in:
a) a decrease in real gross domestic product.
b) a decrease in voluntary unemployment.
c) a decrease in aggregate supply.
d) a decrease in the natural rate of unemployment.
e) a decrease in unplanned inventories.
Question 4) If businesses are experiencing an unplanned increase in inventories, which of the

following is most likely to be true?
a) The economy is growing and will continue to grow until a new equilibrium level of
spending is reached.
b) Aggregate demand is less than output, and the level of spending will decrease.
c) Aggregate demand is greater than output, and the level of spending will increase.
d) Planned investment is greater than planned saving, and the level of spending will
decrease.
e) Planned investment is less than planned saving, and the level of spending will
increase.
Question 5) Which of the following statements best describes the impact of a decrease in
Japanese income on aggregate demand in the United States?
a) Aggregate demand will decrease because demand for U.S. exports decreases.
b) Aggregate demand will decrease because the value of the U.S. dollar decreases
relative to the Japanese yen.
c) There will be no change in aggregate demand because U.S. aggregate demand
depends only on the income of U.S. consumers.
d) Aggregate demand will increase because a decrease in income in Japan causes an
increase in income in the U.S.
e) Aggregate demand will increase because interest rates in the U.S. decrease.
Adjustments in the long run
Activity 1
Based on the graph
A) Based on the graph above, the economy is in:
a) a recessionary gap.
b) an inflationary gap.
B) Which of the following policy responses would a Keynesian favor? Check all that apply:
a) increase taxes
f) decrease taxes
C) Based on the Keynesian response identified above, show the change on the graph.
D) Which change(s) would occur that a Classical economist would say are most effective for
bringing the economy back to its long run equilibrium?
a) increase taxes
f) decrease taxes
E) Based on the Classical response identified above, show the change on the graph.
Multiple- Choice Questions
Question 1) If an economy’s short-run aggregate supply curve is upward sloping, a Keynesian

would argue that an increase in government spending will most likely result in a decrease in
the:
a) real level of output.
b) price level.
c) unemployment rate.
d) interest rate.
e) government’s budget deficit.
Question 2) The classical economists argued that involuntary unemployment would be

eliminated by:
a) increasing government spending to increase aggregate demand.
b) increasing the money supply to stimulate investment spending.
c) maintaining the growth of the money supply at a constant rate.
d) self-correcting market forces stemming from flexible prices and wages.
e) decreasing corporate income taxes to encourage investment.
Question 3) Which of the following policies would a Keynesian recommend during a period
of high unemployment and low inflation?
a) decreasing taxes to stimulate aggregate demand

b) decreasing the money supply to reduce aggregate demand
c) decreasing government spending to stimulate aggregate supply
d) balancing the budget to stimulate aggregate supply
e) imposing wage and price controls to stimulate aggregate supply
Question 4) Suppose the economy of a country is currently in a recessionary gap. A classical

economist would argue that which of the following will occur?
a) Rising wages will shift the aggregate demand curve to the right, producing full
employment.
b) The economy will remain in its current equilibrium level of output because of sticky
wages.
c) Rising wages will shift the short-run aggregate supply curve to the right, producing
full employment.
d) Falling wages will shift the short-run aggregate supply curve to the right, producing
full employment.
e) Falling wages will shift the aggregate demand curve to the right, producing full
employment.
Question 5) An important assumption in Keynesian theory is that:
a) Price rigidity will cause downturns in the economy to self-correct.

b) Prices are sticky and decreases in aggregate demand will lead to an increase in
unemployment.
c) When aggregate demand is inadequate, prices will fall.
d) When interest rates are high, many businesses borrow money.
e) Changes in the money supply are the major cause of changes in real output and price
level.
Conclusion
A decrease in aggregate demand (for example, from a decrease in real wealth) will lead to a
lower level of real GDP and lower price level. The economy will be operating below full
employment, in a recession, with cyclical unemployment. As you know, there are two
responses to this concern: Classical and Keynesian.
With the Classical view, flexible wages and prices should result in lower wages and an increase
(outward or rightward shift) in the short-run aggregate supply curve, bringing the equilibrium
back towards full employment. Market forces, not government intervention, will bring the
economy back to full employment.
With the Keynesian view, wage rigidity or stickiness can result in continued and persistent
cyclical unemployment. Intervention in the form of expansionary fiscal or monetary policy is
needed to increase (a rightward shift) aggregate demand and increase real GDP, reducing
cyclical unemployment. In this case, the economy will return to its full employment GDP.
Course book
Aggregate supply
Prof Ashok Thomas

IIM Kozhikode
Introduction
visit!
This unit will help you understand the concept of aggregate supply in both the short-run and
the long-run. Aggregate supply relates to the real value of the goods and services supplied by
all producers in the economy. Clearly, this value will be sensitive to quantity of inputs (e.g.,
labor and machinery) used and the state of technology.
You will examine the three possible shapes of the aggregate supply curve—horizontal (a fixed-
price case relevant in the more immediate time frame), upward sloping (or short run), and
vertical (long run or Classical) —based on the underlying assumptions made. A horizontal
aggregate supply curve assumes a fixed prices. An upward sloping aggregate supply curve
assumes that input costs and inflationary expectation are sticky or unchanging in the short run.
And a vertical aggregate supply curve assume flexibility of input prices and inflationary
expectations.
There are factors that shift the short-run aggregate supply curve. If productivity, input prices,
or inflationary expectations change the short-run aggregate supply curve will shift.
Additionally, you will discover that the long-run aggregate supply curve is vertical. This is
because input prices and inflationary expectations are fully flexible in the long run. This
vertical long-run aggregate supply curve can shift with changes in the quantity and or quality
of inputs changing or with changes in technology. At any point in time, this long-run aggregate
supply curve measures the potential real GDP or the economy. This leads to introducing the
concept of economic growth or an increase in the maximum sustainable potential real GDP of
the economy.
An understanding of short-run and long-run aggregate supply, coupled with aggregate demand,
permits you to analyze the short-run and long-run economic performance of the aggregate
economy.
Think of all of the many types of businesses that you see around you. This concept of aggregate
supply gives you a way to understand the overall impact of these firms on economic activity.
Sometimes you look at individual firms and the way they function, but sometimes it is helpful
to consider them in the aggregate. For instance, changes in key input costs or changes in
productivity will have an impact on most firms, and you can then predict the impact on
economic activity in both the short run and the long run.
Learning Objectives
You will learn how to construct a short-run aggregate supply curve and a long-run aggregate
supply curve, and you will learn the assumptions for both curves.
You will also learn the determinants of each curve and be able to illustrate changes in these
determinants with your aggregate supply curves.
You will then be able to use these components of an aggregate supply and demand model for
macroeconomic analysis.
Short run aggregate supply
In this activity, you will understand the assumptions behind and determinants of short-run
aggregate supply (SRAS) and be able to use these for analysis. You will be able to graph
the SRAS and appropriately shift the curve when relevant changes occur.
A graph of aggregate supply has the aggregate price level in the economy on the vertical axis
and real gross domestic product (GDP) on the horizontal axis. The aggregate price level may
be expressed as an index—say, 100 in the base year. A 10 percent increase in prices would thus
increase the index to 110. Real GDP is measured in dollars.
Let's begin with a very special case of the aggregate supply curve. This case—referred to as a
fixed-price case, immediate case, or simple Keynesian case—has a perfectly horizontal
aggregate supply curve. Firms can and will increase levels of output without output price
increases to motivate such production increases. Economists feel that this horizontal aggregate
supply curve is relevant only at low levels of output, compared to the full employment output
level. Within an economy with output well below potential, firms—eager for sales—will
increase output without corresponding output price increases.
More likely, in the short run, firms will require an increase in prices to increase real output.
Thus the short-run aggregate supply curve will be upward sloping. The positive relationship
between the price level and the quantity of real GDP supplied can be explained in two ways:
1. With a fixed nominal wage and diminishing marginal product of labor, firms must be offered
price increases to find it profitable to hire more labor and to produce more output. Thus, higher
price levels are needed to increase the aggregate output level.
2. With a fixed nominal wage, a higher price level leads to a reduction in the real wage. With
a reduction in the real wage, firms find it attractive to hire more labor and to produce more
output.
An increase in the short-run aggregate supply curve (or a shift of the curve to the right) means
that any level of real GDP can now be produced with a lower price level. The short-run
aggregate supply curve will increase or shift to the right with a reduction in any input price or
an increase in productivity. Such a shift is called a positive supply shock, as there will be a
lower aggregate price level associated with each level of real GDP.
A decrease in the short-run aggregate supply curve (or a shift of the curve to the left) means
that any level of real GDP must now be produced with a higher price level. The short-run
aggregate supply curve will decrease or shift to the left with an increase in any input price or a
decrease in productivity. Such a shift is called a negative supply shock, as there will be a higer
aggregate price level associated with each level of real GDP.
Activity 1
Now assume that in Econoland, input costs decline.
a) draw the new SRAS curve.
Now assume that in Econoland, labor productivity declines.
b) draw the new SRAS curve.
Activity 2
Draw a short-run aggregate supply curve for each of the following scenarios and show the
appropriate change.
i. increase in the price level

ii. decrease in business taxes
iii. increase in business regulations
iv. decrease in the price of all forms of energy
v. decrease in the availability of natural resources
Conclusion
You should now understand the assumptions of the short-run aggregate supply curve. Well
below full employment wages and prices may be sticky or fixed. In this case, the short-run
aggregate supply curve will be horizontal, called the fixed-price case. This is a very Keynesian
perspective.
More generally, the short-run aggregate supply curve will be upward sloping. A higher price
level is needed to induce a greater quantity of real GDP. You should also know the determinants
of short-run aggregate supply and be able to explain changes in short-run aggregate supply
from changes in the factors. For instance, a decrease in the wage rate would increase aggregate
supply or shift it to the right. Each level of real GDP is now associated with a lower price level.
Multiple Choice Questions
Question 1) If a short-run aggregate supply curve is upward sloping, what is assumed about
inflationary expectations?
a) Inflation expectations are held constant.
b) Inflationary expectations are fully flexible.
c) Inflationary expectations vary directly with output prices.
d) Inflationary expectations vary indirectly with output prices.
e) Inflationary expectations increase more quickly than output prices.
Explanation: An upward sloping short-run aggregate supply curve assumes that inflationary
expectations are unchanging. With unchanging inflationary expectations, any change in the
price level changes firms' levels of profit. With the change in profits firms change their output
level. This creates an upward sloping aggregate supply curve in the short run.
Question 2) If the price of a key input like oil decreases, what would happen to short-run
aggregate supply and employment?
a) Short-run aggregate supply would shift right and employment would decrease.
b) Short-run aggregate supply would shift left and employment would decrease.
c) Short-run aggregate supply would remain the same and employment would increase.
d) Short-run aggregate supply would shift right and employment would increase.
e) Short-run aggregate supply would shift left and employment would increase
Explanation: Key inputs costs are a determinant of short-run aggregate supply and therefore
when they change, the short-run aggregate supply curve shifts to reflect this change. If the price
of oil decreases, short-run aggregate supply increases reflecting the lower costs at every level
of prices. When short-run aggregate supply increases at each price level output and therefore
employment are both greater.
Question 3)In the short run, what happens to aggregate supply when business taxes increase?
a) shifts to the left

b) shifts to the right
c) remains the same
d) becomes vertical
e) becomes horizontal
Explanation: As a determinant of short-run aggregate supply, when business taxes increase,

short-run aggregate supply shifts to the left. Firms costs are higher at every level of prices and
they therefore decrease output at every price level.
Long run aggregate supply
In this part of the lesson, you will learn the assumptions of a long-run aggregate supply curve
and how to construct this curve.
The long-run aggregate supply curve represents potential output at full employment. In the
long run, all input prices and output prices are flexible and competitive. As a result, there will
be full employment of resources and all the output produced will be sold. The economy will
be at its long-run maximum sustainable level of output—often called potential output, or the
full-employment level of real GDP. The long-run aggregate supply curve (LRAS) will be
vertical. Thus, this maximum sustainable output level is invariant to the price level, or
perfectly inelastic.
The quantity of inputs and the state of technology will determine the actual level of potential
output. In the short run, production may occur at a level of real GDP either above or below
potential GDP. However, we assume that such a level of output is not sustainable and that the
economy will move to the full-employment potential output in the long run.
At this full employment level of real GDP, there will be no involuntary (or cyclical)
unemployment. There will be individuals voluntarily unemployed, moving between jobs.
This frictional unemployment is the unemployment that is included in the full-employment
unemployment rate, often called the natural rate of unemployment—typically estimated as
between 4.5% and 5.5%.
The LRAS represents economic potential, as does a production-possibilities curve. An

increase in long-run aggregate supply (or a shift of the curve to the right) represents an
increase in the potential of the economy, showing economic growth. Factors that can cause
increased long-run aggregate supply (LRAS) include technological progress—or productivity
increases—as well as increases in the quantity and/or quality of natural resources, human
resources, or capital resources. Because the long-run aggregate supply curve illustrates the
same concept as the production-possibility frontier, when economic growth occurs, these
curves shift (to the right for LRAS and outward for PPF). Long-run aggregate supply can
decrease (or shift to the left) with decreases in the quantity and/or quality of natural
resources, human resources, or capital resources. Also, with any long-run decrease in
productivity, the LRAS would shift to the left.
Question 1) In Econoland, there is a strong increase in business confidence and increases in

inputs for manufacturing and energy. What effect, if any, will this have on LRAS?
a) Increase
b) Decrease
c) Remain the Same
Explanation: Long-run aggregate supply or potential GDP will increase with the increase in
inputs and the curve shifts to the right.
Question 2) In Econoland, there is 7-year period of annual business tax and property tax
increases. What effect, if any, will this have on LRAS?
a) Increase
b) Decrease
c) Remain the Same
Explanation: Long-run aggregate supply will decrease. With consistent increases in taxes, the
ability of the economy to increase potential output will be impacted in a negative way. This is
illustrated by the curve shifting to the left.
Question 3) Which of the following combinations would cause an increase in LRAS?
a) decrease in capital stock and increase in productivity

b) increase in property taxes and productivity
c) increase in capital stock and increase in productivity
d) decrease in capital stock and decrease in productivity
e) increase in business taxes and increase input prices
Explanation: An increase in capital stock and an increase in productivity increase the

productive capacity of the economy. This would be illustrated by shifting the long-run
aggregate supply to the right.
Activity 1
In Econoland, there is a sudden discovery of a new source of clean, efficient energy. Draw a
long-run aggregate supply curve (LRAS) and show the effect that this discovery would have
on the LRAS. Explain your reasoning.
Compare your graph and give explanation to the ones given below.
Question 4) Long-run aggregate supply represents:
a) potential output at full employment.

b) actual nominal output.
c) spending from all sectors of the economy at various price levels.
d) actual output at zero unemployment.
e) potential output at zero unemployment.
Explanation: Long-run aggregate supply represents the level of output that is possible if all
resources are fully and efficiently employed, or full employment.
Question 5) Changes in which of the following determinants would shift both short-run and
long-run aggregate supply?
a) wages
b) inflation expectations
c) business taxes
d) technology
e) oil prices
Explanation: Changes in technology would shift both short-run and long-run aggregate
supply. Any changes in the cost of production or inflation expectations would shift only
the short-run aggregate supply curve.
Question 6) Which of the following would decrease long-run aggregate supply?
a) increases in imports
b) increases in wealth
c) decreases in government spending
d) decreases in inflationary expectations
e) decreases in the capital stock
Explanation: When capital stock declines, the aggregate supply curve decreases because the
quantity of resources available for production has declined. A change in imports, wealth or in
government spending changes only aggregate demand. Changes in inflationary expectations
would shift the short-run aggregate supply curve.
Question 7) What is the reason that the long-run aggregate supply curve shows no relationship
between the price level and output?
a) Input prices are flexible, but output prices are inflexible.

b) Input prices are flexible, but inflation expectations are inflexible.
c) Some input prices are flexible and some are inflexibile.
d) All input prices and inflation expectations are fully flexible.
e) Both input prices and inflation expectations are inflexible.
Explanation: The long-run aggregate supply curve is vertical because any change in the price
level causes input prices and inflation expectations to adjust so that the level of output remains
at full employment in the long run.
Question 8) A decrease in the price of inputs will cause which of the following to occur in
the short run?
a) an increase in the aggregate demand and an increase in the price level

b) a decrease in the aggregate demand and an increase in the price level
c) an increase in the short-run aggregate supply and a decrease in the price level
d) an increase in the short-run aggregate supply and an increase in the price level
e) a decrease in the short-run aggregate supply and a decrease in the price level
Explanation: Input costs are a determinant of short-run aggregate supply and therefore
changes in input costs shift short-run aggregate supply curves. If input costs decline, short-run
aggregate supply would shift to the right, illustrating that producers are able to produce more
at every price level and price level is lower at each output level.
Question 9) An increase in which of the following is consistent with an outward shift of the
production-possibilities curve?
a) transfer payments
b) aggregate demand
c) long-run aggregate supply
d) income tax rates
e) exports
Explanation: An outward shift of the production-possibilities curve reflects an increase in the

potential level of output at full employment. A long-run aggregate supply curve illustrates
potential output at full employment and an increase in this curve also reflects an increase in
potential output at full employment.
Assignment
Assume that the United States economy is currently operating at an equilibrium below full
employment.
A. Draw a correctly labeled graph of aggregate demand and aggregate supply, and show
each of the following.
(i) Long-run aggregate supply
(ii) Current equilibrium output and price level
B. Now assume a significant increase in the world price of oil, a major production input for
the United States. Show on your graph in part (a) how the increase in the oil price affects
each of the following in the short run.
(i) Short-run aggregate supply
(ii) Real output and price level
C. Given your answer in part (b), explain what will happen to unemployment in the United
States in the short run.
Conclusion
You should now recognize that the long-run aggregate supply curve represents potential
output at full employment. In the long run, all input prices and output prices are flexible and
competitive. As a result, there will be full employment of resources and all the output
produced will be sold. This means that the long-run aggregate supply curve (LRAS) will be
vertical. Thus, this maximum sustainable output level is invariant to the price level. Also,
economic growth can be shown as a rightward shift of the long-run aggregate supply curve,
showing a higher maximum sustainable output level
Course book
Aggregate supply
Prof Ashok Thomas

IIM Kozhikode
Introduction
visit!
This unit will help you understand the concept of aggregate supply in both the short-run and
the long-run. Aggregate supply relates to the real value of the goods and services supplied by
all producers in the economy. Clearly, this value will be sensitive to quantity of inputs (e.g.,
labor and machinery) used and the state of technology.
You will examine the three possible shapes of the aggregate supply curve—horizontal (a fixed-
price case relevant in the more immediate time frame), upward sloping (or short run), and
vertical (long run or Classical) —based on the underlying assumptions made. A horizontal
aggregate supply curve assumes a fixed prices. An upward sloping aggregate supply curve
assumes that input costs and inflationary expectation are sticky or unchanging in the short run.
And a vertical aggregate supply curve assume flexibility of input prices and inflationary
expectations.
There are factors that shift the short-run aggregate supply curve. If productivity, input prices,
or inflationary expectations change the short-run aggregate supply curve will shift.
Additionally, you will discover that the long-run aggregate supply curve is vertical. This is
because input prices and inflationary expectations are fully flexible in the long run. This
vertical long-run aggregate supply curve can shift with changes in the quantity and or quality
of inputs changing or with changes in technology. At any point in time, this long-run aggregate
supply curve measures the potential real GDP or the economy. This leads to introducing the
concept of economic growth or an increase in the maximum sustainable potential real GDP of
the economy.
An understanding of short-run and long-run aggregate supply, coupled with aggregate demand,
permits you to analyze the short-run and long-run economic performance of the aggregate
economy.
Think of all of the many types of businesses that you see around you. This concept of aggregate
supply gives you a way to understand the overall impact of these firms on economic activity.
Sometimes you look at individual firms and the way they function, but sometimes it is helpful
to consider them in the aggregate. For instance, changes in key input costs or changes in
productivity will have an impact on most firms, and you can then predict the impact on
economic activity in both the short run and the long run.
Learning Objectives
You will learn how to construct a short-run aggregate supply curve and a long-run aggregate
supply curve, and you will learn the assumptions for both curves.
You will also learn the determinants of each curve and be able to illustrate changes in these
determinants with your aggregate supply curves.
You will then be able to use these components of an aggregate supply and demand model for
macroeconomic analysis.
Short run aggregate supply
In this activity, you will understand the assumptions behind and determinants of short-run
aggregate supply (SRAS) and be able to use these for analysis. You will be able to graph
the SRAS and appropriately shift the curve when relevant changes occur.
A graph of aggregate supply has the aggregate price level in the economy on the vertical axis
and real gross domestic product (GDP) on the horizontal axis. The aggregate price level may
be expressed as an index—say, 100 in the base year. A 10 percent increase in prices would thus
increase the index to 110. Real GDP is measured in dollars.
Let's begin with a very special case of the aggregate supply curve. This case—referred to as a
fixed-price case, immediate case, or simple Keynesian case—has a perfectly horizontal
aggregate supply curve. Firms can and will increase levels of output without output price
increases to motivate such production increases. Economists feel that this horizontal aggregate
supply curve is relevant only at low levels of output, compared to the full employment output
level. Within an economy with output well below potential, firms—eager for sales—will
increase output without corresponding output price increases.
More likely, in the short run, firms will require an increase in prices to increase real output.
Thus the short-run aggregate supply curve will be upward sloping. The positive relationship
between the price level and the quantity of real GDP supplied can be explained in two ways:
1. With a fixed nominal wage and diminishing marginal product of labor, firms must be offered
price increases to find it profitable to hire more labor and to produce more output. Thus, higher
price levels are needed to increase the aggregate output level.
2. With a fixed nominal wage, a higher price level leads to a reduction in the real wage. With
a reduction in the real wage, firms find it attractive to hire more labor and to produce more
output.
An increase in the short-run aggregate supply curve (or a shift of the curve to the right) means
that any level of real GDP can now be produced with a lower price level. The short-run
aggregate supply curve will increase or shift to the right with a reduction in any input price or
an increase in productivity. Such a shift is called a positive supply shock, as there will be a
lower aggregate price level associated with each level of real GDP.
A decrease in the short-run aggregate supply curve (or a shift of the curve to the left) means
that any level of real GDP must now be produced with a higher price level. The short-run
aggregate supply curve will decrease or shift to the left with an increase in any input price or a
decrease in productivity. Such a shift is called a negative supply shock, as there will be a higer
aggregate price level associated with each level of real GDP.
Activity 1
Now assume that in Econoland, input costs decline.
a) draw the new SRAS curve.
Now assume that in Econoland, labor productivity declines.
b) draw the new SRAS curve.
Activity 2
Draw a short-run aggregate supply curve for each of the following scenarios and show the
appropriate change.
i. increase in the price level

ii. decrease in business taxes
iii. increase in business regulations
iv. decrease in the price of all forms of energy
v. decrease in the availability of natural resources
Conclusion
You should now understand the assumptions of the short-run aggregate supply curve. Well
below full employment wages and prices may be sticky or fixed. In this case, the short-run
aggregate supply curve will be horizontal, called the fixed-price case. This is a very Keynesian
perspective.
More generally, the short-run aggregate supply curve will be upward sloping. A higher price
level is needed to induce a greater quantity of real GDP. You should also know the determinants
of short-run aggregate supply and be able to explain changes in short-run aggregate supply
from changes in the factors. For instance, a decrease in the wage rate would increase aggregate
supply or shift it to the right. Each level of real GDP is now associated with a lower price level.
Multiple Choice Questions
Question 1) If a short-run aggregate supply curve is upward sloping, what is assumed about
inflationary expectations?
a) Inflation expectations are held constant.
b) Inflationary expectations are fully flexible.
c) Inflationary expectations vary directly with output prices.
d) Inflationary expectations vary indirectly with output prices.
e) Inflationary expectations increase more quickly than output prices.
Question 2) If the price of a key input like oil decreases, what would happen to short-run
aggregate supply and employment?
a) Short-run aggregate supply would shift right and employment would decrease.
b) Short-run aggregate supply would shift left and employment would decrease.
c) Short-run aggregate supply would remain the same and employment would increase.
d) Short-run aggregate supply would shift right and employment would increase.
e) Short-run aggregate supply would shift left and employment would increase
Question 3)In the short run, what happens to aggregate supply when business taxes increase?
a) shifts to the left

b) shifts to the right
c) remains the same
d) becomes vertical
e) becomes horizontal
Long run aggregate supply
In this part of the lesson, you will learn the assumptions of a long-run aggregate supply curve
and how to construct this curve.
The long-run aggregate supply curve represents potential output at full employment. In the
long run, all input prices and output prices are flexible and competitive. As a result, there will
be full employment of resources and all the output produced will be sold. The economy will
be at its long-run maximum sustainable level of output—often called potential output, or the
full-employment level of real GDP. The long-run aggregate supply curve (LRAS) will be
vertical. Thus, this maximum sustainable output level is invariant to the price level, or
perfectly inelastic.
The quantity of inputs and the state of technology will determine the actual level of potential
output. In the short run, production may occur at a level of real GDP either above or below
potential GDP. However, we assume that such a level of output is not sustainable and that the
economy will move to the full-employment potential output in the long run.
At this full employment level of real GDP, there will be no involuntary (or cyclical)
unemployment. There will be individuals voluntarily unemployed, moving between jobs.
This frictional unemployment is the unemployment that is included in the full-employment
unemployment rate, often called the natural rate of unemployment—typically estimated as
between 4.5% and 5.5%.
The LRAS represents economic potential, as does a production-possibilities curve. An

increase in long-run aggregate supply (or a shift of the curve to the right) represents an
increase in the potential of the economy, showing economic growth. Factors that can cause
increased long-run aggregate supply (LRAS) include technological progress—or productivity
increases—as well as increases in the quantity and/or quality of natural resources, human
resources, or capital resources. Because the long-run aggregate supply curve illustrates the
same concept as the production-possibility frontier, when economic growth occurs, these
curves shift (to the right for LRAS and outward for PPF). Long-run aggregate supply can
decrease (or shift to the left) with decreases in the quantity and/or quality of natural
resources, human resources, or capital resources. Also, with any long-run decrease in
productivity, the LRAS would shift to the left.
Question 1) In Econoland, there is a strong increase in business confidence and increases in

inputs for manufacturing and energy. What effect, if any, will this have on LRAS?
a) Increase
b) Decrease
c) Remain the Same
Question 2) In Econoland, there is 7-year period of annual business tax and property tax
increases. What effect, if any, will this have on LRAS?
a) Increase
b) Decrease
c) Remain the Same
Question 3) Which of the following combinations would cause an increase in LRAS?
a) decrease in capital stock and increase in productivity

b) increase in property taxes and productivity
c) increase in capital stock and increase in productivity
d) decrease in capital stock and decrease in productivity
e) increase in business taxes and increase input prices
Activity 1
In Econoland, there is a sudden discovery of a new source of clean, efficient energy. Draw a
long-run aggregate supply curve (LRAS) and show the effect that this discovery would have
on the LRAS. Explain your reasoning.
Compare your graph and give explanation to the ones given below.
Question 4) Long-run aggregate supply represents:
a) potential output at full employment.

b) actual nominal output.
c) spending from all sectors of the economy at various price levels.
d) actual output at zero unemployment.
e) potential output at zero unemployment.
Question 5) Changes in which of the following determinants would shift both short-run and
long-run aggregate supply?
a) wages
b) inflation expectations
c) business taxes
d) technology
e) oil prices
Question 6) Which of the following would decrease long-run aggregate supply?
a) increases in imports
b) increases in wealth
c) decreases in government spending
d) decreases in inflationary expectations
e) decreases in the capital stock
Question 7) What is the reason that the long-run aggregate supply curve shows no
relationship between the price level and output?
a) Input prices are flexible, but output prices are inflexible.

b) Input prices are flexible, but inflation expectations are inflexible.
c) Some input prices are flexible and some are inflexibile.
d) All input prices and inflation expectations are fully flexible.
e) Both input prices and inflation expectations are inflexible.
Question 8) A decrease in the price of inputs will cause which of the following to occur in
the short run?
a) an increase in the aggregate demand and an increase in the price level

b) a decrease in the aggregate demand and an increase in the price level
c) an increase in the short-run aggregate supply and a decrease in the price level
d) an increase in the short-run aggregate supply and an increase in the price level
e) a decrease in the short-run aggregate supply and a decrease in the price level
Question 9) An increase in which of the following is consistent with an outward shift of the
production-possibilities curve?
a) transfer payments
b) aggregate demand
c) long-run aggregate supply
d) income tax rates
e) exports
Assignment
Assume that the United States economy is currently operating at an equilibrium below full
employment.
A. Draw a correctly labeled graph of aggregate demand and aggregate supply, and show
each of the following.
(i) Long-run aggregate supply
(ii) Current equilibrium output and price level
B. Now assume a significant increase in the world price of oil, a major production input for
the United States. Show on your graph in part (a) how the increase in the oil price affects
each of the following in the short run.
(i) Short-run aggregate supply
(ii) Real output and price level
C. Given your answer in part (b), explain what will happen to unemployment in the United
States in the short run.
Conclusion
You should now recognize that the long-run aggregate supply curve represents potential
output at full employment. In the long run, all input prices and output prices are flexible and
competitive. As a result, there will be full employment of resources and all the output
produced will be sold. This means that the long-run aggregate supply curve (LRAS) will be
vertical. Thus, this maximum sustainable output level is invariant to the price level. Also,
economic growth can be shown as a rightward shift of the long-run aggregate supply curve,
showing a higher maximum sustainable output level
Course book
Prof Ashok Thomas

IIM Kozhikode
Session 7: Keynesian Framework: Building Blocks
Introduction
In the period from 1929 to 1933, referred to as the beginning of the Great Depression,
economists had expected that competitive markets would reduce unemployment and reduce
surpluses, as had occurred often in prior recessions. In this case, however, wages were falling
but unemployment continued to increase, reaching approximately 25% in the United States in
January 1933. Thus, many began to question the prevailing Classical view of the economic
world. John Maynard Keynes, writing in the United Kingdom in the 1930s, particularly felt
that wage and price rigidities could keep an economy for a prolonged period of time in a below
full-employment equilibrium.
Essentially, the Keynesian view argues that there are impediments to wages and prices falling
to equilibrium levels. This phenomenon can be referred to as “sticky” wages and prices,
“downwardly rigid” wages and prices, or “downwardly inflexible” wages and prices. While
over a longer period of time, excess supply could pressure downward wages and prices, there
can be significant periods of excess supply, generating unemployment in labor markets and
surpluses in product markets.
Within labor markets, wage inflexibility can result from legal minimum wages above
equilibrium or union contracts. Also, employers may find it profitable over the long run to pay
a wage premium to attract good workers (sometimes referred to as “efficiency wages”) and to
maintain higher wages even in periods of slack demand. Within product markets, large firms
wishing to avoid destabilizing competition may maintain prices above equilibrium and have
temporary surpluses.
If the economy has the tendency to settle below full employment, with significant
unemployment, an appropriate government policy response would be to stimulate demand, to
increase employment and to increase the purchasing of products, moving the economy towards
full employment. Governments can prompt an increase in demand by directly buying goods
and services, reducing taxes to stimulate private spending, or lowering interest rates to
encourage investment and interest-sensitive consumer purchases. These stabilization policies
are frequently referred to as fiscal and monetary policy. In this Keynesian view of the world,
unlike the Classical view of the world, aggregate demand is very important as a determinant of
macroeconomic equilibrium and the level of unemployment in the economy. Inadequate
aggregate demand can lead to a short-run macroeconomic equilibrium with significant
unemployment, well above the full-employment rate of 4.5 to 6%.
Multiple choice questions
Question 1) According to the Keynesian view, the Great Depression could be characterized
as a period during which:
a) Prices and wages increased rapidly.

b) Prices stayed low, but wages increased rapidly.
c) There was a prolonged excess supply of labor.
d) There was a prolonged excess demand for labor.
e) Prices increased rapidly, but wages stayed low.
Explanation: The Great Depression was a period during which unemployment was high. In
other words, there was a prolonged excess supply of labor. Keynesian thinking doesn't see
wages as flexible and therefore the excess supply of labor can continue for extended periods.
Question 2) According to the Keynesian view, which of the following is an inappropriate

short-term policy if the economy is in a recession?
a) Increasing government spending
b) Decreasing the deficit
c) Decreasing sales taxes
d) Decreasing interest rates
e) Decreasing income taxes
Explanation: According to the Keynesian view, the government should increase demand in
the short term if the economy is in a recession. This could involve increasing spending or
lowering taxes. Each of these policies would lead to greater deficits. Decreasing the deficit on
the part of government would decrease aggregate demand. This would be inappropriate in the
Keynesian view.
Question 3) According to the Keynesian view, unemployment caused by inadequate demand

could persist because:
a) Workers do not have the skills that firms need.
b) Workers receiving unemployment benefits have no incentive to look for employment.
c) Wages are rigid.
d) Government has set an interest rate that is too low.
e) Technological developments have induced firms to replace workers with machines
and robots.
Explanation: According to the Keynesian view, recessions caused by inadequate demand occur
when unemployment persists due to rigid wages. If workers’ skills don’t match the skills needed by
firms, or if workers have an incentive to remain unemployed for the sake of benefits, or if
technological developments make certain workers obsolete, there would indeed be some
unemployment in the economy, but it wouldn’t be the type of unemployment caused by inadequate
demand. When the government sets too low an interest rate, it would lead to an increase in demand
which would cause lower unemployment.
Activity 1: Assume that a country is concerned about experiencing a high level of unemployment.
How would Classical and Keynesian economists differ in their approaches to reducing unemployment?
Activity 2
Referencing the animation above, which of the following best describes the economic effect?
a) Decrease in Quantity of Aggregate Demand caused by the Interest Rate Effect

b) Increase in Quantity of Aggregate Demand caused by the Interest Rate Effect
c) Decrease in Quantity of Aggregate Demand caused by the Real Balances Effect
d) Increase in Quantity of Aggregate Demand caused by the Real Balances Effect
e) Decrease in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
f) Increase in Quantity of Aggregate Demand caused by the Foreign Purchases Effect
Activity 3
Referencing the animation above, which of the the following best describes the economic
effect?

Activity 4
effect?

Conclusion
You should now be comfortable with the three reasons the aggregate demand curve has a
negative slope when graphed as the relationship between the general price level and output
measure as Real GDP. You should note that all three reasons begin with a change in the price
level and that you are explaining the impact of that change.
Be careful as you move forward to avoid confusing a change in some other variable other than
price level, which, as you will see, will cause a shift in the entire aggregate demand curve.
In this section, you have explored movements along the aggregate demand curve -- and
strengthened your ability to explain the causes for movements along the curve.
Aggregate demand
Question 4) As a result of a higher price level, domestic consumers have less purchasing power
with their cash balances in checking and savings accounts and therefore decrease their quantity
demanded for goods and services. This decrease is most likely due directly to:
a) Real Balance effect

b) Foreign Purchase effect
c) Interest Rate effect
d) An increase in imports
e) A decrease in exports
Explanation: The correct answer is the Real Balance Effect. A higher price level will cause
the nominal cash balances in consumers’ savings accounts and checking accounts to have less
purchasing power.
Question 5) As a result of higher interest rates, consumers buy less interest sensitive goods
like automobiles. This is an example of the:

d) All of the above
e) None of the above
Explanation: The answer is none of the above. Since there is no mention of a price level
change, then there is no simple movement along the Aggregate Demand Curve to be
explained by any of the effects in a-c. As you will see, this type of change will cause a shift
of the Aggregate Demand Curve.
Question 6) As a result of a higher price level, consumers need more money to make purchases
that they want. This increase in demand for money causes higher interest rates. The higher
interest rates cause consumers and businesses to reduce their demand for interest sensitive
goods. This effect is known as:

d) All of the above
Explanation: The answer is the Interest Rate effect. Notice that the question began with a change in
the price level. The question then perfectly describes the Interest Rate effect.

d) All of the above
Question 8) Assume all other factors remain constant when interest rates fall. Then
consumers would be able to borrow easier and the demand for real goods and services would
rise. This is an example of:
a) Interest Rate effect

b) Real Balance effect
c) Foreign Purchase effect
d) All of the above
Explanation: This is a tough question at this point. If you got it right, give yourself a star! The
correct answer is none of the above. The first three responses help describe changes in the
amount of real goods and services demanded as a result of changes in the price level. Here, we
are considering a change in interest rates autonomously and not as the result of a price level
change. It turns out this kind of autonomous change causes the entire demand curve to shift,
and that is the subject of our next section.
Question 9) Assume that income rises in Germany and Germans demand more U.S. goods
and services as a result. This is an example of:
a) the Interest Rate effect

b) the Real Balance effect
c) the Foreign Purchase effect
d) all of the above
e) none of the above
Explanation: The correct answer is none of the above. The type of change described in the
stem is an autonomous change, not the result of an initial change in the price level. Therefore,
a-c responses would not apply.
Determinants of Aggregate Demand

Introduction
In this section, you will learn the determinants of aggregate demand. A change in one of these
variables will actually cause a shift of the aggregate demand curve as opposed to a movement
along the curve. In essence, any change that affects aggregate demand, other than price level
changes, will shift the aggregate demand curve.
As mentioned in the previous section, it will be important for you to know these determinants
and how they affect aggregate demand, so that you will be able to understand how monetary
and fiscal policies are implemented and how they work.
Activity 1) Show the shifts in AD
Situation A
Assume the government increases government spending to build more interstate highways
and repair bridges along existing highways.
Situation B
Assume interest rates rise as a result of increased government borrowing to finance the highway
improvement projects.
Situation C
Assume the U. S. dollar increases in value (or appreciates) on the foreign exchange market. In other
words, it costs more Japanese Yen to buy a U. S. Dollar.
Situation D
Assume business confidence rises.
Situation E
Assume the general price level rises.
Situation F
Assume the level of income in China rises faster than the level of income in the U.S.
Activity 2
Consider the following economic fluctuations and what effect they would have on aggregate demand.
Draw your own graphs
1. Increase in Interest Rate
2. Higher Price Level
3. Decrease in Government Spending
4. Increase in Real Balances due to Decrease in Price Levels
5. Increase in Exports due to Decrease in Dollar Value (Foreign Exchange)
6. Increase in Personal Income Taxes
7. Increase in Consumer Confidence
You should now understand that changes in some economic factors, like the exchange rate or the
nominal interest rate, will shift the aggregate demand (AD) curve. Expansionary changes, like a tax
reduction or lower interest rate, will shift the AD curve to the right or increase AD at every price
level. Contractionary changes, like a reduction in government spending, will shift the AD curve to the
left or decrease AD at every price level.
Question 1) An increase in which of the following will increase aggregate demand?
a) Taxes
b) Government spending
c) The federal funds rate
d) Reserve requirements
e) The discount rate
Explanation: An increase in government spending will shift the Aggregate Demand Curve to
the right. An increase in taxes would shift it to the left as will all of the changes in monetary
policy to be studied later in the course.
Question 2) An increase in the international value of the United States dollar will tend to
cause U. S. exports to:
a) fall and aggregate demand to increase.
b) rise and aggregate demand to increase.
c) fall and aggregate demand to decrease.
d) rise and aggregate demand to decrease.
e) not change and aggregate demand to not change.
Explanation: The correct answer is "fall and aggregate demand to decrease" because U. S.
exports will now appear more expensive to foreigners. Thus, a decrease in Net Exports (Xn)
will then cause a decrease in aggregate demand.
Question 3) Which of the following changes would cause an economy’s Aggregate Demand
curve to shift to the right?
a) An increase in spending on imports
b) An increase in autonomous consumption spending
c) An increase in interest rates
d) A decrease in the money supply
e) A decrease in the overall price level in the economy
Explanation: The correct answer is "an increase in autonomous consumption spending." An

autonomous increase in consumption would increase the amount of Aggregate demand at every
price level thus shifting the Aggregate Demand curve to the right. Response "A decrease in the
overall price level in the economy" is interesting in that, the amount of aggregate demand
increases as a result of the decrease in the price level, but, as we have stressed in these first two
sections, this change is just a movement along the Aggregate Demand Curve. The remaning
responses would shift the curve to the left.
Question 4) Aggregate Demand may be measured by adding:
a) consumption, investment, savings, and imports

b) savings, government spending, and business inventories
c) consumption, investment, government spending, and net exports
d) domestic private expenditures and government spending
e) domestic expenditure and imports
Explanation: The correct answer is "consumption, investment, government spending, and net
exports." There are four sectors of spending which constitute Aggregate Demand:
Consumption, Business Investment, Government, and Net exports.
Question 5) Which of the following would cause the aggregate demand curve to shift to the
left?
a) Providing investment tax credits for businesses
b) Higher value of the dollar on the foreign exchange market
c) Reducing personal income tax rates
d) Increase in consumer confidence
e) Faster increase in foreign countries’ income compared to the US
Explanation: The correct answer is "Higher value of the dollar on the foreign exchange
market." If the value of the dollar rises (or appreciates), US goods will be relatively more
expensive for foreigners and they will buy less, while foreign goods will look cheaper to US
consumers and they will import more. Thus, net exports will decrease and shift aggregate
demand to the left. All other responses will cause aggregate demand to shift to the right.
The Multiplier Effect
Introduction
You now know that a change in the price level will cause a movement along the aggregate
demand curve, reflecting a change in the amount of real goods and services demanded.
You also know that an autonomous change in any one of the four sectors of aggregate
demand (C, Ig, G, Xn) will cause a shift in the aggregate demand curve reflecting a change in
the amount of real goods and services demanded at every price level.
Activity
In this section, you will see that an autonomous change in any one of the four sectors can
result in a much greater change in aggregate demand (and even real GDP). The additional
increase in aggregate demand is called the multiplier effect. It is important to consider the
multiplier effect in determining the magnitude of necessary fiscal and monetary policy
changes in the effort to fine tune the economy. Activity Overview
Now you will try some exercises that will help you practice the multiplier effects. It is
important to bear in mind that any autonomous change in one of the four sectors of aggregate
demand (C, Ig, G, Xn) will result in a much greater change in aggregate demand as a result of
the multiplier effect.
Activity 1
Assume the government increases government spending by $10 billion to improve border
security. Also, assume the marginal propensity to consume is .75. What will be the maximum
total change in aggregate demand based on the increase in government spending?
multiplier=1/0.25=4
Total changes in aggregate demand: 4 x $10 Billion = $40 Billion
Activity 2
Assume consumers become concerned about the direction the economy is headed and they
decrease their spending on consumer goods and services by $800 million. Assuming the
marginal propensity to save is .2, what will be the maximum total change in aggregate
demand?
multiplier=1/0.2=5
Total change in aggregate demand:
5 x $-800 million = $-4 Billion
Activity 3
Assume the exchange rate for the Mexican Peso changes such that it costs more Dollars to
buy a Peso. As a result, Americans buy less Mexican goods and services while Mexicans buy
more American goods and services. Assume the result of these changes is an increase in U.S.
Net Exports of $2 billion. Assuming the marginal propensity to consume is .8, what will be
the maximum total change in aggregate demand?
multiplier=1/0.2=5
total change in aggregate demand
5 x $2 Billion =$10 Billion
Question 1) An increase in the marginal propensity to consume causes an increase in which
of the following?
a) Marginal propensity to save

b) Spending multiplier
c) Savings rate
d) Exports
e) Aggregate supply
Explanation: The correct answer is the Spending multiplier. Looking at the formula for the
spending multiplier (M= 1/1-MPC), you can see that an increase in MPC will reduce the
denominator, and thus increase the value of the multiplier. This makes sense intuitively as well
in that more spending generates more income.
Question 2) In an economy with lump-sum taxes and no international sector, assume that the
marginal propensity to consume is equal to .8. Which of the following will necessarily be
true?
a) The economy will be running a deficit, since consumption expenditures exceed

personal saving.
b) Wealth will tend to accumulate in the hands of a few people.
c) A $10 increase in consumption spending will bring about an $80 increase in
disposable income.
d) The government expenditure multiplier will be equal to 5.
e) An increase in taxes of $80 million will result in a decrease in aggregate demand of
$5 million.
Explanation: The correct answer is the government expenditure multiplier will be equal to 5. checking
the formula (M = 1/1-MPC): M = 1/1-.8 or 1/.2 or 5.
Question 3) Assume the government feels the economy is “overheated” and would like to see
aggregate demand decrease by $200 billion. By how much would the government need to
change government spending if the marginal propensity to save in the economy is .25?
a) $50 billion increase

b) $50 billion decrease
c) $200 billion increase
d) $200 billion decrease
e) $25 billion decrease
Explanation: The correct answer is a $50 Billion decrease. Since the marginal propensity to
save is .25, the multiplier is = 4, or (1/.25). If government decreases government spending by
$50 Billion, then Aggregate Demand will decrease by 4 times or by $200 Billion
Question 4) Assume the government increases government spending by $800 billion and the
ultimate change in aggregate demand is approximately $4 trillion, then the economy’s
marginal propensity to consume must be:
a) .2
b) .8
c) 5
d) $3.2 trillion
e) $800 billion
Explanation: The correct answer is .8. If the increase in government spending of $800 billion
results in an increase in aggregate demand of $4 trillion, that is a fivefold increase meaning the
multiplier is 5. For the multiplier to be equal to 5, then the marginal propensity to consume
must be .8. The multiplier would be calculated as (1/1-.8) which is equal to 5.
Question 5) Assume consumers have a new bright and positive attitude about the economy
and they increase spending on consumer goods by a total of $400 billion. As a result,
aggregate demand ultimately increases by approximately $1.6 trillion. Assuming the marginal
propensity to consume for the economy is .75, by what amount did the consumers initially
change their saving?
a) 4
b) .25
c) -$400 billion
d) -$1.2 trillion
e) no change in saving
Explanation: The answer is -$400 billion. Consumers have two choices concerning what they can do
with their income. They can either spend it or save it. Once again, that is why the sum of the marginal
propensity to save plus the marginal propensity to consume is equal to 1. Therefore, if the consumers
decide to increase their spending by $400 billion, then they must reduce their saving by $400 billion.
Marginal Propensity to Consume (MPC) is .75. Then aggregate demand will eventually:
a) decrease and shift to the left by a maximum of $10 billion

b) increase and shift to the right by a maximum of $10 billion
c) decrease and shift to the left by a maximum of $40 billion
d) increase and shift to the right by a maximum of $40 billion
e) not change since this is an autonomous increase
Explanation: The correct answer is increase and shift to the right by a maximum of $40 billion.
Since the multiplier is 4 or 1/(1 - 0.75) = 1/0.25, the initial increase is $10 billion, but due to
the multiplier effect, the eventual change may be as great as $40 billion.
Question 7) The three reasons the aggregate demand curve slopes down and to the right
when graphed as a function of the price level are:
a) real balance effect (or wealth effect), foreign purchases effect, and interest rate effect
b) real balance effect (or wealth effect), price level effect, and interest rate effect
c) real balance effect (or wealth effect), foreign purchases effect, and price level effect
d) income effect, wealth effect, and price level effect
e) income effect, personal gain effect, and price level effect
Explanation: The correct answer is the real balance effect, foreign purchases effect, and interest rate
effect. All of these effects start with a change in the price level and represent the three important reasons
that more real goods and services will be demanded at lower price levels and less real goods and services
will be demanded at higher price levels.
Question 8) Assume business confidence rises and as a result, business investment spending
rises by $4 billion dollars. Also, assume the marginal propensity to consume is .8. This
increase in spending would be considered:
a) The interest rate effect and aggregate demand would increase ultimately by $20
billion.
b) An autonomous change and aggregate demand would increase ultimately by $20
billion.
c) The interest rate effect and aggregate demand would increase ultimately by $4 billion.
d) An autonomous change and aggregate demand would increase ultimately by $4
billion.
e) An autonomous change and aggregate demand would increase ultimately by $3.2
billion.
Explanation: The correct answer is an autonomous change and Aggregate Demand would increase
ultimately by $20 billion. Since this change is a result of something other than a change in the price
level, it represents an autonomous change. Since the marginal propensity to consume is .8, the multiplier
is 5 = 1/(1-.8) = 1/.2 and Aggregate Demand will increase theoretically and ultimately by $20 Billion
(5 x $4 Billion)
Question 9) If the aggregate demand curve shifts to the left, a likely cause would be:
An increase in income in Germany
a) A decrease in the value of the dollar on the foreign exchange

b) An increase in the price level
d) A decrease in taxes
Explanation: The correct answer is an increase in the interest rates. An increase in interest
rates would make the purchase of goods and services that require consumers and businesses to
borrow become more expensive. An increase in the price level would cause a decrease in the
amount of real goods and services demanded or a movement along the Aggregate Demand
curve. The other three responses would cause an increase or shift to the right of the Aggregate
Demand curve.
Question 10) If you observe the aggregate demand curve shifting to the right by $50 billion
dollars based on an increase of $5 billion in business investment spending, then most likely:
a) Government spending was also increased by $40 billion.

b) Government spending was also increased by $10 billion.
c) The marginal propensity to save is .9.
d) The marginal propensity to consume is .9.
e) The marginal propensity to consume is $40 billion.
Explanation: The correct answer is the marginal propensity to consume is .9. Since the
ultimate increase in aggregate demand is 10 times the original increase in spending, the
multiplier is 10. Therefore, the marginal propensity to consume must be 0.9. The multiplier
would be calculated as 1/(1 - 0.9), which is equal to 10.
Question 11) If you observe the quantity of aggregate demand increases by $4 billion with
no change/shift in aggregate demand, then a likely explanation is:
a) There has been a decrease in the price level.

b) There has been an increase in the price level.
c) Government spending has increased by 1 billion and the marginal propensity to
consume is .75.
d) Government spending has increased by 1 billion and the marginal propensity to
consume is .8.
e) Government spending has increased by 1 billion and the marginal propensity to
consume is 4.
Explanation: The correct answer is "there has been a decrease in the price level." If there has
been no change in Aggregate Demand, then the increase in the amount of Aggregate Demand
must be due to a movement along the existing Aggregate Demand curve due to a change in the
price level. In this case, the price level would have to decrease to cause the increase of $4
billion in Aggregate Demand.
Course book
Prof Ashok Thomas

IIM Kozhikode
Session 7: Keynesian Framework: Building Blocks
Introduction
In the period from 1929 to 1933, referred to as the beginning of the Great Depression,
economists had expected that competitive markets would reduce unemployment and reduce
surpluses, as had occurred often in prior recessions. In this case, however, wages were falling
but unemployment continued to increase, reaching approximately 25% in the United States in
January 1933. Thus, many began to question the prevailing Classical view of the economic
world. John Maynard Keynes, writing in the United Kingdom in the 1930s, particularly felt
that wage and price rigidities could keep an economy for a prolonged period of time in a below
full-employment equilibrium.
Essentially, the Keynesian view argues that there are impediments to wages and prices falling
to equilibrium levels. This phenomenon can be referred to as “sticky” wages and prices,
“downwardly rigid” wages and prices, or “downwardly inflexible” wages and prices. While
over a longer period of time, excess supply could pressure downward wages and prices, there
can be significant periods of excess supply, generating unemployment in labor markets and
surpluses in product markets.
Within labor markets, wage inflexibility can result from legal minimum wages above
equilibrium or union contracts. Also, employers may find it profitable over the long run to pay
a wage premium to attract good workers (sometimes referred to as “efficiency wages”) and to
maintain higher wages even in periods of slack demand. Within product markets, large firms
wishing to avoid destabilizing competition may maintain prices above equilibrium and have
temporary surpluses.
If the economy has the tendency to settle below full employment, with significant
unemployment, an appropriate government policy response would be to stimulate demand, to
increase employment and to increase the purchasing of products, moving the economy towards
full employment. Governments can prompt an increase in demand by directly buying goods
and services, reducing taxes to stimulate private spending, or lowering interest rates to
encourage investment and interest-sensitive consumer purchases. These stabilization policies
are frequently referred to as fiscal and monetary policy. In this Keynesian view of the world,
unlike the Classical view of the world, aggregate demand is very important as a determinant of
macroeconomic equilibrium and the level of unemployment in the economy. Inadequate
aggregate demand can lead to a short-run macroeconomic equilibrium with significant
unemployment, well above the full-employment rate of 4.5 to 6%.
Question 1) According to the Keynesian view, the Great Depression could be characterized
as a period during which:
a) Prices and wages increased rapidly.

b) Prices stayed low, but wages increased rapidly.
c) There was a prolonged excess supply of labor.
d) There was a prolonged excess demand for labor.
e) Prices increased rapidly, but wages stayed low.
Question 2) According to the Keynesian view, which of the following is an inappropriate

short-term policy if the economy is in a recession?
a) Increasing government spending
b) Decreasing the deficit
c) Decreasing sales taxes
d) Decreasing interest rates
e) Decreasing income taxes
Question 3) According to the Keynesian view, unemployment caused by inadequate demand

could persist because:
a) Workers do not have the skills that firms need.
b) Workers receiving unemployment benefits have no incentive to look for employment.
c) Wages are rigid.
d) Government has set an interest rate that is too low.
e) Technological developments have induced firms to replace workers with machines
and robots.
Activity 1: Assume that a country is concerned about experiencing a high level of unemployment.
How would Classical and Keynesian economists differ in their approaches to reducing unemployment?
Activity 2
Referencing the animation above, which of the tfollowing best describes the economic effect?

Activity 3
effect?

Activity 4
effect?

Conclusion
You should now be comfortable with the three reasons the aggregate demand curve has a
negative slope when graphed as the relationship between the general price level and output
measure as Real GDP. You should note that all three reasons begin with a change in the price
level and that you are explaining the impact of that change.
Be careful as you move forward to avoid confusing a change in some other variable other than
price level, which, as you will see, will cause a shift in the entire aggregate demand curve.
In this section, you have explored movements along the aggregate demand curve -- and
strengthened your ability to explain the causes for movements along the curve.
Aggregate demand
Question 4) As a result of a higher price level, domestic consumers have less purchasing power
with their cash balances in checking and savings accounts and therefore decrease their quantity
demanded for goods and services. This decrease is most likely due directly to:

d) An increase in imports
e) A decrease in exports
Question 5) As a result of higher interest rates, consumers buy less interest sensitive goods
like automobiles. This is an example of the:

d) All of the above

d) All of the above
Question 7) As a result of a higher price level, consumers need more money to make
purchases that they want. This increase in demand for money causes higher interest rates. The
higher interest rates cause consumers and businesses to reduce their demand for interest
sensitive goods. This effect is known as:

d) All of the above
Question 8) Assume all other factors remain constant when interest rates fall. Then
consumers would be able to borrow easier and the demand for real goods and services would
rise. This is an example of:
a) Interest Rate effect

b) Real Balance effect
c) Foreign Purchase effect
d) All of the above
Question 9) Assume that income rises in Germany and Germans demand more U.S. goods
and services as a result. This is an example of:
a) the Interest Rate effect

b) the Real Balance effect
c) the Foreign Purchase effect
d) all of the above
e) none of the above
Determinants of Aggregate Demand

Introduction
In this section, you will learn the determinants of aggregate demand. A change in one of these
variables will actually cause a shift of the aggregate demand curve as opposed to a movement
along the curve. In essence, any change that affects aggregate demand, other than price level
changes, will shift the aggregate demand curve.
As mentioned in the previous section, it will be important for you to know these determinants
and how they affect aggregate demand, so that you will be able to understand how monetary
and fiscal policies are implemented and how they work.
Activity 1) Show the shifts in AD
Situation A
Assume the government increases government spending to build more interstate highways
and repair bridges along existing highways.
Situation B
Assume interest rates rise as a result of increased government borrowing to finance the highway
improvement projects.
Situation C
Assume the U. S. dollar increases in value (or appreciates) on the foreign exchange market. In other
words, it costs more Japanese Yen to buy a U. S. Dollar.
Situation D
Assume business confidence rises.
Situation E
Assume the general price level rises.
Situation F
Assume the level of income in China rises faster than the level of income in the U.S.
Activity 2
Consider the following economic fluctuations and what effect they would have on aggregate demand.
Draw your own graphs
1. Increase in Interest Rate
2. Higher Price Level
3. Decrease in Government Spending

4. Increase in Real Balances due to Decrease in Price Levels
5. Increase in Exports due to Decrease in Dollar Value (Foreign Exchange)
6. Increase in Personal Income Taxes
7. Increase in Consumer Confidence
You should now understand that changes in some economic factors, like the exchange rate or the
nominal interest rate, will shift the aggregate demand (AD) curve. Expansionary changes, like a tax
reduction or lower interest rate, will shift the AD curve to the right or increase AD at every price
level. Contractionary changes, like a reduction in government spending, will shift the AD curve to the
left or decrease AD at every price level.
Question 1) An increase in which of the following will increase aggregate demand?
a) Taxes
b) Government spending
c) The federal funds rate
d) Reserve requirements
e) The discount rate
Question 2) An increase in the international value of the United States dollar will tend to
cause U. S. exports to:
a) fall and aggregate demand to increase.
b) rise and aggregate demand to increase.
c) fall and aggregate demand to decrease.
d) rise and aggregate demand to decrease.
e) not change and aggregate demand to not change.
Question 3) Which of the following changes would cause an economy’s Aggregate Demand
curve to shift to the right?
a) An increase in spending on imports
b) An increase in autonomous consumption spending
d) A decrease in the money supply
e) A decrease in the overall price level in the economy
Question 4) Aggregate Demand may be measured by adding:
a) consumption, investment, savings, and imports

b) savings, government spending, and business inventories
c) consumption, investment, government spending, and net exports
d) domestic private expenditures and government spending
e) domestic expenditure and imports
Question 5) Which of the following would cause the aggregate demand curve to shift to the
left?
a) Providing investment tax credits for businesses
b) Higher value of the dollar on the foreign exchange market
c) Reducing personal income tax rates
d) Increase in consumer confidence
e) Faster increase in foreign countries’ income compared to the US
The Multiplier Effect
Introduction
You now know that a change in the price level will cause a movement along the aggregate
demand curve, reflecting a change in the amount of real goods and services demanded.
You also know that an autonomous change in any one of the four sectors of aggregate
demand (C, Ig, G, Xn) will cause a shift in the aggregate demand curve reflecting a change in
the amount of real goods and services demanded at every price level.
Activity
In this section, you will see that an autonomous change in any one of the four sectors can
result in a much greater change in aggregate demand (and even real GDP). The additional
increase in aggregate demand is called the multiplier effect. It is important to consider the
multiplier effect in determining the magnitude of necessary fiscal and monetary policy
changes in the effort to fine tune the economy. Activity Overview
Now you will try some exercises that will help you practice the multiplier effects. It is
important to bear in mind that any autonomous change in one of the four sectors of aggregate
demand (C, Ig, G, Xn) will result in a much greater change in aggregate demand as a result of
the multiplier effect.
Activity 1
Assume the government increases government spending by $10 billion to improve border
security. Also, assume the marginal propensity to consume is .75. What will be the maximum
total change in aggregate demand based on the increase in government spending?
Activity 2
Assume consumers become concerned about the direction the economy is headed and they
decrease their spending on consumer goods and services by $800 million. Assuming the
marginal propensity to save is .2, what will be the maximum total change in aggregate
demand?
Activity 3
Assume the exchange rate for the Mexican Peso changes such that it costs more Dollars to
buy a Peso. As a result, Americans buy less Mexican goods and services while Mexicans buy
more American goods and services. Assume the result of these changes is an increase in U.S.
Net Exports of $2 billion. Assuming the marginal propensity to consume is .8, what will be
the maximum total change in aggregate demand?
Question 1) An increase in the marginal propensity to consume causes an increase in which

of the following?
a) Marginal propensity to save

b) Spending multiplier
c) Savings rate
d) Exports
e) Aggregate supply
Question 2) In an economy with lump-sum taxes and no international sector, assume that the
marginal propensity to consume is equal to .8. Which of the following will necessarily be
true?
a) The economy will be running a deficit, since consumption expenditures exceed

personal saving.
b) Wealth will tend to accumulate in the hands of a few people.
c) A $10 increase in consumption spending will bring about an $80 increase in
disposable income.
d) The government expenditure multiplier will be equal to 5.
e) An increase in taxes of $80 million will result in a decrease in aggregate demand of
$5 million.
Question 3) Assume the government feels the economy is “overheated” and would like to see
aggregate demand decrease by $200 billion. By how much would the government need to
change government spending if the marginal propensity to save in the economy is .25?
a) $50 billion increase
b) $50 billion decrease
c) $200 billion increase
d) $200 billion decrease
e) $25 billion decrease
ultimate change in aggregate demand is approximately $4 trillion, then the economy’s
marginal propensity to consume must be:
a) .2
b) .8
c) 5
d) $3.2 trillion
e) $800 billion
Question 5) Assume consumers have a new bright and positive attitude about the economy
and they increase spending on consumer goods by a total of $400 billion. As a result,
aggregate demand ultimately increases by approximately $1.6 trillion. Assuming the marginal
propensity to consume for the economy is .75, by what amount did the consumers initially
change their saving?
a) 4
b) .25
c) -$400 billion
d) -$1.2 trillion
e) no change in saving
Marginal Propensity to Consume (MPC) is .75. Then aggregate demand will eventually:
a) decrease and shift to the left by a maximum of $10 billion

b) increase and shift to the right by a maximum of $10 billion
c) decrease and shift to the left by a maximum of $40 billion
d) increase and shift to the right by a maximum of $40 billion
e) not change since this is an autonomous increase
Question 7) The three reasons the aggregate demand curve slopes down and to the right
when graphed as a function of the price level are:
a) real balance effect (or wealth effect), foreign purchases effect, and interest rate effect
b) real balance effect (or wealth effect), price level effect, and interest rate effect
c) real balance effect (or wealth effect), foreign purchases effect, and price level effect
d) income effect, wealth effect, and price level effect
e) income effect, personal gain effect, and price level effect
Question 8) Assume business confidence rises and as a result, business investment spending
rises by $4 billion dollars. Also, assume the marginal propensity to consume is .8. This
increase in spending would be considered:
a) The interest rate effect and aggregate demand would increase ultimately by $20
billion.
b) An autonomous change and aggregate demand would increase ultimately by $20
billion.
c) The interest rate effect and aggregate demand would increase ultimately by $4 billion.
d) An autonomous change and aggregate demand would increase ultimately by $4
billion.
e) An autonomous change and aggregate demand would increase ultimately by $3.2
billion.
Question 9) If the aggregate demand curve shifts to the left, a likely cause would be:
An increase in income in Germany
a) A decrease in the value of the dollar on the foreign exchange

b) An increase in the price level
d) A decrease in taxes
Question 10) If you observe the aggregate demand curve shifting to the right by $50 billion
dollars based on an increase of $5 billion in business investment spending, then most likely:
a) Government spending was also increased by $40 billion.

b) Government spending was also increased by $10 billion.
c) The marginal propensity to save is .9.
d) The marginal propensity to consume is .9.
e) The marginal propensity to consume is $40 billion.
Question11) If you observe the quantity of aggregate demand increases by $4 billion with no
change/shift in aggregate demand, then a likely explanation is:
a) There has been a decrease in the price level.

b) There has been an increase in the price level.
c) Government spending has increased by 1 billion and the marginal propensity to
consume is .75.
d) Government spending has increased by 1 billion and the marginal propensity to
consume is .8.
e) Government spending has increased by 1 billion and the marginal propensity to
consume is 4.
Course book
Cost of living & Unemployment
Prof Ashok Thomas

IIM Kozhikode
Sessions 2 and 3: Cost of living & Unemployment
Question1) If the price level rises in year 2, from year 1 and the real GDP rises in the same
period, which of the following is true?
a) Real GDP will increase by more than nominal GDP does, from year 1 to year 2.
b) Nominal and real GDP must change by the same percentages from year 1 to year 2.
c) Real GDP only increases because the price level increased.
d) Nominal GDP will increase by more than real GDP does, from year 1 to year 2.
e) Nominal GDP will fall from year 1 to 2.
Explanation: Nominal GDP is the product of the price level and the real GDP. If both real
GDP and price levels are rising, the nominal GDP will increase even more than the real GDP.
Question 2) If the nominal GDP increased by 15% from year 1 to year 2, and the price level
changed from 100 to 110 from year 1 to year 2, which of the following is true?
a) Real GDP increased between year 1 and year 2 by approximately 5%

b) Real GDP fell by 10% between the two years.
c) The rate of inflation was 15% between the two years.
d) Real GDP increased by 15% between year 1 and year 2.
e) The price level must have increased by 5% from year 1 to year 2.
Explanation: If the price level changed from 100 to 110, there is an inflation rate of (110-
100)/100=10%. The change in real GDP is approximately the difference between the change
in nominal GDP and the inflation rate. Thus, it is approximately equal to 15%-10%=5%.
Chapter 3
Unemployment
Introduction
In this section you will learn about important and informative measures of employment or
unemployment. You will learn how to calculate the official unemployment rate, the labor force
participation rate, and learn who is considered to be unemployed and employed in the economy.
Additionally, you will learn what the measure of the natural rate of unemployment or full
employment means, and what types of unemployment are considered by economists.
Question 1) If an individual becomes discouraged and stops looking for work, which of the
following will happen?
a) The labor force participation rate remains constant and the unemployment rate falls.
b) The labor force participation rate and the unemployment rate each remain constant.
c) The labor force participation rate falls, and the unemployment rate falls.
d) The labor force participation rate falls and the unemployment rate rises.
e) The labor force participation rate increases and the unemployment rate falls.
Explanation: If an individual becomes discouraged and stops looking for work, the individual is no
longer considered part of the labor force so the labor force participation rate falls. The individual is also
no longer considered unemployed, because he or she has stopped looking for work, so the
unemployment rate will fall.
Question 2) Which of the following is not in the labor force?
a) Charles, who wants to work but has given up looking for work until the weather
improves.
b) Mary, who works part-time but wishes for work full time.
c) John, who has a graduate degree but is working as a waiter.
d) Carl, who does not have work but applied for work at a local factory.
e) Melissa, who just graduated from business school and is currently seeking
employment as an accountant.
Explanation: Because Mary and John are working, even though they wish to work more hours and are
underemployed respectively, they are counted in the labor force. Carl and Melissa, although they are
not currently working, are seeking work so they are also counted in the labor force. Charles, however,
is neither working nor currently seeking employment so he is not included in the labor force.
Question 3) Anika is a part-time independent contractor and wants to work full time
a) the potential labor force

b) labor force
c) employed
d) unemployed
e) not in the labor force
Question 4) Suresh is a magician that works one day a week

b) labor force
c) employed
d) unemployed
Question 5) Holly is not working, but is sending applications for full time baseball coaching
jobs

b) labor force
c) employed
d) unemployed
Question 6) Clark has graduated from college and decided to spend a year sailing before
looking for work

b) labor force
c) employed
d) unemployed
Question 7) Huanwei is retired but substitutes for the local school district on occasion

b) labor force
c) employed
d) unemployed
Question 8) Artie Bob is a freshman in high school and dreams of being a currency trader in
the future

b) labor force
c) employed
d) unemployed
Question 9) Kelley, after unsuccessful applying for jobs for the last three months, has
stopped looking for a new job

b) labor force
c) employed
d) unemployed
Question 10) Fredo was working part time temporarily and now has a full time job with
benefits

b) labor force
c) employed
d) unemployed
Question 11) Fekru is retired but volunteers for Meals on Wheels

b) labor force
c) employed
d) unemployed
Question 12) Carlos is a construction worker that has been laid off for 3 weeks due to snow

b) labor force
c) employed
d) unemployed
Activity 1
The following data is for Ferrara:
• 14,000 population
• 10,000 are 16 years of age and over
• 400 are not working but actively looking for work
• 6000 are working full time
• 1,000 have stopped looking for work
• 1,600 are retired
• 1,000 are working part time and wanting to work part time
• 600 are working part time and want to work full time
A) What is Ferrara’s labor force participation rate? Write your answer like this "10%"
B) What is the unemployment rate? Write your answer like this "10%"
C) What are two limitations of the unemployment rate you calculated above?
D) If some people that are unemployed stop looking for work, what happens to the
unemployment rate?
Activity 2
Categorize each of the following examples of unemployment into one of the following
categories: frictional, structural and cylical.
A) Declan lost his job as a parts installer when an assembly line was installed in the plant
where he worked.
a) frictional
b) structural
c) cyclical
B) Gertrude has been laid off from her job as an accountant because of a downturn in
economic activity.
a) frictional
b) structural
c) cyclical
C) Moshe has finished graduate school and is weighing various job offers.
a) frictional
b) structural
c) cyclical
D) Guillermo, an oil field worker, leaves Texas to job hunt in North Dakota where the oil
industry is booming.
a) frictional
b) structural
c) cyclical
E) A recession causes Gywn to lose his teaching job.
a) frictional
b) structural
c) cyclical
F) Kevin, a cashier, losses his job when self-check-out system is installed at his store.
a) frictional
b) structural
c) cyclical
G) Resolving which type of unemployment causes debates about appropriate public

policies?
H) Define the natural rate of unemployment.
Multiple choice
I) The population 16 years of age and over is 5000 in country X. Of these 5000 people:
200 are not working but actively looking for work; 3000 are working full time; 500 are
working part time and wanting to work part time; 300 are working part time and want
to work full time.
What is the potential labor force in country X?
a) 3000
b) 5000
c) 8000
d) 11,000
e) Cannot be determined
Explanation: The potential labor force consists of all individuals at least 16 years old so it is
5000.
J) The population 16 years of age and over is 5000 in country X. Of these 5000 people:
to work full time.
What is the labor force participation rate in country X?
a) 5%
b) 10%
c) 25%
d) 80%
e) 100%
Explanation: Individuals either working or looking for work are considered to be part of the
labor force. Here, the labor force includes those not working but actively looking for work
(200), those working full time (3000), those working part time and wanting to work part time
(500), and those working part time and wanting to work full time (300). Thus, the total labor
force is 200+3000+500+300=4000. The labor force participation rate is the ratio of the labor
force (4000) to the potential labor force (5000). 4000/5000=80%
K) The population 16 years of age and over is 5000 in country X. Of these 5000 people:
to work full time.
What is the unemployment rate in country X?
a) 4%
b) 5%
c) 6%
d) 20%
e) 25%
Explanation: The unemployment rate is the ratio of those unemployed and actively looking
for work (200) to those in the labor force (4000). 200/4000=5%
L) Which of the following will add to unemployment in a country?
a) Mary quits her job as a teacher to go to law school.

b) John, a chef, is demoted from being a chef to being a waiter in a restaurant.
c) Eileen, having looked for work for two months, quits looking and decides to vacation.
d) Harry, with a large family to support, has his hours of work cut from 40 to 20 per
week.
e) Sam, finishes nursing school, and begins to look for full time work.
M) When an individual who was unemployed finds work, which of the following is true?
a) The unemployment rates falls and the labor force participation rate falls.
b) The unemployment rate falls and the labor force participation rate increases.
c) The number of discouraged workers falls and the labor force participation rate
increases.
d) The unemployment rate falls and the labor force participation rate remains unchanged.
e) The population increases and the labor force participation rate increases.
Conclusion
You now have a good understanding of what unemployment measures. Often people think that
anyone that is not working is considered to be unemployed, but you now know that there is a
much more precise definition; an individual must be 16 or over, must be not working, and must
be actively seeking employment. Also, the concept of the natural rate of unemployment is
significant in analyzing economic activity. Remember that this is when there is zero cyclical
unemployment.
Course book
Real and Nominal GDP
Prof Ashok Thomas

IIM Kozhikode
Session 3: Real and Nominal GDP (Using Price index)
Introduction
Throughout this module, you will visit Ferrara, a place created to illustrate macroeconomic
challenge concepts. You will learn from the experiences of the people in Ferrara. Enjoy your
visit!
Nominal values and real values are different, but related measures. By understanding the
differences, you can better determine the true costs and benefits of economic
decisions. Nominal (or current) values are those that are actually stated or observed.
Real values are those expressed in constant prices and are unobserved: rather, they are
calculated from the nominal values using price level changes. The point of using real values is
to eliminate the effects of price changes (inflation or deflation). This distinction between
nominal and real applies to measuring variables -- like GDP, income, wages, money supply,
wealth, and interest rates.
The real values of those variables have significance in economic decision-making; that is,
decisions should be based on real values, not nominal values.
Important terms
• nominal variable
• real variable
• current prices
• constant prices
• inflation
• price index
• income
• wealth
• interest rates
You will be able to see how savings and borrowing decisions are affected by real, not nominal,
interest rates. As you learn how to determine the real interest rate and other real variables which
are unobserved, you will have an additional economic tool to help you in making decisions.
The costs and benefits of borrowing, for instance, to purchase a car will be much clearer to
you.
Learning Objectives
• You will be able to calculate both nominal and real values.
• You will understand what nominal variables measure and what real variables
measure.
• You will be able to use this understanding for analysis of economic situations.
Activity 1
Use the information in the table below to practice price index and inflation calculations. This
example involves calculation of a simple price index based on gas prices. Thus, you can
assume that a gallon of gas is the only thing in your market basket each year.
Remember that any price index can be calculated as:
• (Cost of market basket in given year) / (Cost of market basket in base year)
The inflation rate is simply the percent change in the price index from one year to the next:
Question 1) If the nominal gross domestic product (GDP) of the nation of Hypothetica
increased in 2007 relative to the previous year, it must be true that in Hypothetica in 2007:
a) Both the price level and the real GDP have increased.
b) Neither the price level nor the real GDP has increased.
c) The price level increased by a larger percentage than did the real GDP.
d) The price level increased by a smaller percentage than did real GDP.
e) The price level and/or the real GDP has increased.
Explanation: Nominal GDP is real GDP multiplied by the price level. So, an increase in
nominal GDP could have resulted from an increase in either factor (real GDP or the price
level).
Question 2) The major difference between real and nominal gross domestic product (GDP) is
that real GDP:
a) excludes government transfer payments.

b) excludes imports.
c) is adjusted for price-level changes using a price index.
d) measures only the value of final goods and services.
e) measures the price of a market basket of goods purchased by a typical urban
consumer.
Explanation: The definition of a real variable is that it adjusts for changes in prices over
time. Both real and nominal GDP exclude transfer payments and imports. Both real and
nominal GDP measure the value of final goods and services. The price of a market basket is
used in calculating the consumer price index (CPI).
Question 3) Suppose a typical consumer buys the following quantities of three commodities
in 2003 and 2004.
Which of the following can be concluded about the consumer price index (CPI) for this
individual from 2003 to 2004?
Answer: It increased by 25%
Explanation: The cost of the market basket in 2003 was $80 (5*$6 + 2*$7 + 3*$12). The
cost of the market basket in 2004 was $100 (5*$5 + 2*$9 + 3*$19). That is a 25% increase
[($100 – $80) / $80 ] * 100 = 25%
Question 4) If real gross domestic product (GDP) is increasing at 3 percent per year and
nominal gross domestic product is increasing at 7 percent per year, which of the following is
necessarily true?
a) The price level is increasing.

b) Unemployment is increasing.
c) Exports exceed imports.
d) The economy is in a recession.
e) The government is running a budget deficit.
Explanation: The price level accounts for the difference between nominal GDP and real GDP.
In this example, the price level must be increasing by 4% per year. The 7% change in nominal
GDP is the sum of a 3% real increase in GDP and the 4% increase in the price level.
Question 5) If a worker’s nominal wage rate increases from $10 to $12 per hour and at the
same time the general price level increases by 10 percent, the worker’s real wage has:
a) approximately decreased by 10%.

b) approximately decreased by 20%.
c) approximately increased by 10%.
d) approximately increased by 20%.
e) not changed.
Explanation: The nominal wage increased by 20% ($2/$10). But since prices increased by
10%, real wages increased by only 10% (20% - 10%).
Question 6) The annual inflation rate is expected to be 5 percent over the next 3 years. Juan
plans to take out a 3-year loan to purchase a car. If Juan decides not to take out a loan if the
real interest rate exceeds 3 percent, the highest nominal interest rate he is willing to pay is:
a) 2 percent
b) 3 percent
c) 8 percent
d) 15 percent
e) 25 percent
Explanation: The relationship between these values is: nominal interest rate = real interest
rate + expected inflation. Therefore, nominal interest rate = 3% + 5% = 8%
A) Homework for better understanding
1) In nominal terms, Econoland’s GDP was 15 billion ecobucks last year and is 18 billion
ecobucks this year. If you let last year be the base year, then what value of the price
index for this year would indicate no change in the real value of GDP? Write your
answer like this "4.5".
2) Explain how you derived your answer.

Answer: 18 billion divided by 15 billion
3) Imagine that you are a lender in Econoland and can currently charge an interest rate of
5%. Imagine that you anticipate that inflation will be 2%. What real return do you
expect to receive? Write your answer like this "10%".
4) Explain how you calculated your answer.

Answer: Nominal interest rate = real interest rate + expected inflation
5) As the lender, how would you feel if inflation were actually 1%?
Answer: That would be beneficial, as the real return would increase to 4% (5% - 1%).
6) As the lender, how would you feel if inflation were actually 6%?
Answer: That would be detrimental, as the real return would decrease and actually become
negative (5% - 6% = -1%). In other words, you are not even being compensated enough to account
for inflation.
7) How would your borrowers feel if inflation were actually 1%?

Answer: Borrowers would not like it if inflation were only 1%, as that would mean they are
paying a real return of 4% instead of 3%.
8) How would your borrowers feel if inflation were actually 6%?
Answer: Borrowers would like it if inflation were 6%, as the resulting negative real interest rate
indicates that the real value of the amount repaid at the end of the loan period will be less than the
real value of the amount borrowed.
Question 7) In the country of Agronomia, banks charge 10 percent interest on all loans. If the
general price level has been increasing at the rate of 4 percent per year, the real rate of
interest in Agronomia is:
a) 2.5%
b) 4%
c) 6%
d) 10%
e) 14%
Explanation: The relationship between these values is: real interest rate = nominal interest
rate - inflation. Therefore, real interest rate = 10% - 4%, or 6%.
Question 8) Which of the following would be true if the actual rate of inflation were less
than the expected rate of inflation?
a) Inflation had been underpredicted.

b) The real interest rate had exceeded the nominal interest rate.
c) The real interest rate had been negative.
d) The economy would expand because of the increased investment and spending.
e) People who borrowed funds at the nominal interest rate during this time period would
lose.
Explanation: Nominal interest rates are calculated by adding the expected value of inflation
to the desired real return. Since the nominal rate was calculated using the higher expected rate
of inflation, borrowers are paying a higher nominal rate. Another way to think about this is to
compare the real rate of interest paid, given the two inflation rates. The real interest rate is
calculated as nominal interest rate - inflation. Therefore, the lower-than-expected inflation
rate results in a higher real interest rate, which is bad for borrowers. For example, if the
nominal interest rate is 7% and actual inflation was 4%, the real interest rate would be 3%. In
contrast, if actual inflation rate is 3%, then the real rate is 4%, with lenders benefiting and
borrowers losing.
Question 9) If inflation is 3 percent at the time when a worker’s nominal income increases
from $50,000 to $52,500, then the worker’s real income has:
a) approximately increased by 2%.

b) approximately increased by 5%.
c) approximately decreased by 2%.
d) approximately decreased by 5%.
e) not changed.
Explanation: The worker’s nominal wage increased by 5% (2,500/50,000). Because inflation

is 3%, the worker’s real wage increased by 2% (5% - 3%).
Question 10) The annual inflation rate is expected to be 2 percent over the next four years. If
you take out a four-year loan at a nominal interest rate of 6 percent, what real interest rate are
you paying?
a) 3 percent
b) 4 percent
c) 6 percent
d) 8 percent
e) 12 percent
Explanation: The real interest rate can be calculated as the nominal rate minus expected
inflation.
Question 11) As the price level decreases, what happens to the purchasing power of wealth,
and what does that mean about aggregate demand?
Purchasing power of wealth: increases
Aggregate demand: downward sloping
Explanation: When the price level falls, every dollar can buy more, so the purchasing power
of wealth has increased. This means that the quantity of consumption expenditures will
increase, leading to a greater level of output. The inverse relationship between the price level
and the output level means that aggregate demand is downward sloping.
Question 12) If the actual inflation rate is greater than the expected inflation rate, then
a) inflation has been overpredicted.

b) borrowers win.
c) lenders win.
d) neither borrowers nor lenders win.
e) both borrowers and lenders win.
Explanation: The real interest rate is calculated as the nominal rate minus inflation. Therefore,
when inflation is greater than what was expected, the real interest rate will be lower than what
was expected. A lower real interest rate is good for borrowers but bad for lenders.
Question 13) If real gross domestic product is increasing at 6 percent per year and nominal
gross domestic product is increasing at 5 percent per year, which of the following is
necessarily true?
a) Unemployment is decreasing.
b) The economy is in a recession.
c) The economy is in an expansion.
d) The price level is decreasing.
e) The price level is increasing.
Explanation: Real GDP controls for changes in prices over time. So, output has grown by 6%
with prices held constant. When prices are allowed to change over time (nominal GDP), GDP
grows more slowly, which means that the price level must be falling.
Question 14) Inflation and expected inflation are important determinants of economic
activity. If there is an increase in the expected rate of inflation, will the nominal interest rate
on new loans increase, decrease, or remain unchanged?
As a result of an increase in the expected rate of inflation, the nominal interest rate will
increase.
Question 15) If there is an increase in the expected rate of inflation, will the real interest rate
on new loans increase, decrease, or remain unchanged?
Write your answer like this "increase".
unchanged.
uUnchanged
As a result of an increase in the expected rate of inflation, the real interest rate will remain
unchanged.
Question 16) Assume that the nominal interest rate is 8 percent. Borrowers and lenders
expect the rate of inflation to be 3 percent, and the growth rate of real gross domestic product
is 4 percent.
Calculate the real interest rate
Answer: 5% ( 8%-3%=5%)
Course book
National Income Accounting
Prof Ashok Thomas

IIM Kozhikode
Chapter 1
National Income Accounting
Introduction
This concept is aimed at showing how economists measure the important outcomes of the macro or
aggregate economy. We will discuss measures of production, such as Gross National Product, measures
of employment, such as the labor -force participation rate and the unemployment rate, measures of
price-level change, such as inflation, and finally, measures of the money supply, such as circulating
cash and checking account deposits.
Vocabulary
v Gross domestic product

v Nominal value
v Real value
The news reports that GDP has increased. What does this really mean? Also, suppose that the
unemployment rate is reported to have declined. Is this good? This unit will give you the tools to be
able to understand the state of an economy, and whether there are economic problems. You will be able
to start to formulate policy to address economic problems.
Approaches to measuring GDP
In this section you will develop an understanding of what the primary measure of economic activity,
gross domestic product or GDP measures. Additionally, you will learn three approaches to measuring
GDP.
Do it yourself
What Does and Doesn't Count for GDP?
For each of the following examples, select whether or not the example counts for GDP.
If it does count for GDP, describe the category that it would fall into from either the
expenditure approach or the value of output: C, Ig, G, or Xn, or the income approach: rent,
wages, interest, profit.
If it doesn't count for GDP, explain why it doesn't.
1) A Japanese car manufacturer produces a truck in Texas that has not been sold so the
truck remains in inventory. Is this part of GDP?
YES NO
2) Dev receives a dividend check from his stock holdings. Is this part of GDP?
YES NO
3) A local insurance agency purchases a certified pre-owned automobile for an

employee. Is this part of GDP?
YES NO
4) Govt: buys new file cabinets for member offices. Is this part of GDP?
YES NO
5) The Millers buy pumpkins from the pumpkin farm to carve for Halloween. Is this
part of GDP?
YES NO
6) Serena buys stock in Disney Corp. Is this part of GDP?

YES NO
7) Computers are produced in Ohio to be shipped to Germany. Is this part of GDP?
YES NO
8) Terrence changes the oil in his car. Is this part of GDP?
YES NO
9) Sammie makes a loan to her good friend Danica. Is this part of GDP?
YES NO
10) Granny Sally receives a social security payment. Is this part of GDP?
YES NO
Question 1) Which of the following is included as an addition to the GDP of country of X

during the 2015 year?
a) A social security payment to a retired teacher in country X in 2015.
b) Textiles produced during 2015 in country Z, by a firm owned by a resident of country
X.
c) The value of topsoil lost in country X in 2015.
d) Canned soup produced in 2014 in country X but consumed in 2015.
e) Shoes produced in country X in 2015, but not sold or consumed in 2015.
Explanation: GDP consists of the value of all final goods and services produced within a
country in a given year. Goods produced in the country but consumed at a future date are
counted in the GDP for the year in which they were produced. Transfer payments, depreciation,
and goods produced in other countries are not included in GDP.
Question 2) For which of the following reasons does GDP per capita have limits as a
measure of social welfare for an ordinary person?
a) GDP does not consider the distribution of income and its inequality.
b) GDP includes investment by businesses, as well as by households.
c) GDP overstates the value of home-produced goods.
d) GDP does not count public goods like education.
e) GDP expenditures do not include imported goods.
Explanation: While GDP considers the values of goods and services, it doesn’t include any
information about the distribution of those goods or inequality, which have significant effects
on social welfare. Public goods and imported goods are included in the calculation of GDP.
Home-produced goods are actually excluded from GDP calculations. GDP calculations include
business investments but this does not have a significant impact on the social welfare of
individuals.
Question 3) Which of the following will increase the investment component of GDP, as
measured from the final goods approach, in a particular time period?
a) Shoes produced and sold to the government for use by the military.
b) New automobiles purchased by citizens.
c) Shoes produced within the country but not sold during the time period.
d) Transfer of funds from a parent to a child for educational expenses.
e) Selling of canned soup from a firm’s inventory.
Explanation: The shoe production should be part of GDP, but not shoe consumption. There
will be an increase in inventory for the given year, and inventory change is part of
investment. So, GDP and investment will both increase.
Question 4) Which of the following is NOT counted in GDP of country X during the 2015
year?
a) Automobiles produced in country X during 2015 but not purchased.

b) An export of computers made in country X to a firm in country Y.
c) Production in country Y by a firm owned by a resident of country X.
d) The government of country X hiring a contractor to build a bridge in country X
e) Production of t-shirts in country X by a firm owned by a resident of country A.
Explanation: GDP includes goods produced in country X, regardless of who produces the
goods, but does not include goods produced in country Y even though the firm is owned by a
resident of country X. Exports of computers are included in GDP. Automobiles produced but
not consumed are included in GDP as investments. Government spending is also included in
GDP calculations.
Question 5) Which statement concerning inclusion in GDP is correct?
a) Automobiles produced in country B but imported to country A will count in the GDP
of country A.
b) Imports of consumer goods are frequently counted as final consumption goods and
must be subtracted from GDP as part of net exports.
c) Goods produced in country A but exported to country B are not counted in the GDP
of country A; they are counted in the GDP of country B.
d) Net trade or imports minus exports are added to a country’s GDP. If imports exceed
exports GDP increases.
e) Only imports for private consumption are counted as part of a country’s GDP.
Question 6) Which of the following best explains why transfer payments are not included in
the calculation of gross domestic product?
a) Recipients of transfer payments have not produced or supplied goods and services in
exchange for these payments.
b) Transfer payments are a government expenditure, and government expenditures are
excluded from gross domestic product.
c) Transfer payments are used to pay for intermediate goods, and intermediate goods are
d) Recipients of transfer payments are usually children, and income earned by children is
e) Recipients of transfer payments are sometimes not citizens of the United States.

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Economic Environment

Prof Ashok Thomas

• aggregate demand and real GDP

• Classical and Keynesian theories of economic activity

• the impact of autonomous spending changes on AD and nominal GDP

• the AD/AS model

• the unemployment gap (Contractionary gap) and the inflationary gap

• the inverse relationship between interest rates and investment

A. decrease interest rates and expand the money supply

A. increase government transfer payments and decrease taxes

A. high unemployment and low inflation

Question 5) In an econmy at full employment, a presidential candidate proposes cutting the

• Balanced Budget Multiplier

A. an increase in government expenditure

AD (decreases increases or no change)

The spending multiplier =1/MPS (Marginal to Propensity to Save)

The tax multiplier = - MPC/MPS or the spending multiplier -1.

The balanced budget multiplier =1 times the initial change in G.

A balanced budget still has an impact on GDP.

A. the price level is rising.

Question 3) Expansionary fiscal policy will be most effective when:

A. the economy is at or above full-employment output.

A. a $100 increase in taxes

Activity 3) Suppose the government spends $100 on construction materials.

Short-Run Equilibrium and Long-

Prof Ashok Thomas

As a foundation for understanding short-run macroeconomic adjustments, this unit examines

a) the economy is in a short-run, but not a long-run, macroeconomic equilibrium.

Explanation: An unintended decrease in inventories indicates that the quantity of aggregate

Question 2) A decrease in the general price level would cause:

a) Planned investment will increase.

a) increases real household wealth.

a) There will be an undesired decrease in inventories.

Question 6) The short-run macroeconomic equilibrium requires:

Explanation: The short-run macroeconomic equilibrium requires the quantity of aggregate

What has happened to the price level in Econoland?

What has happened to the quantity of aggregate supply?

a) QAS > QAD

What has happened to the level of inventories in Econoland?

a) QAS > QAD

What has happened to the level of inventories in Econoland?

Question1) An increase in the general price level will:

a) growing business optimism leading to an increase in planned investment.

Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If the

Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. If businesses

a) an increase in aggregate supply.

Explanation: An increase in aggregate demand causes a rightward shift in the aggregate

Question 6) An economy is experiencing rising unemployment and deflation. This could be

a) a leftward shift in the aggregate supply curve.

Explanation: A leftward shift in the aggregate demand curve represents a decrease in

Short run equilibrium and aggregate supply shifts

ii) What caused the undesired buildup of inventories?

iii) Describe the effect of the increase in inventories on price level.

ii) What caused the undesired decrease of inventories?

iii) Describe the effect of the decrease in inventories on price level

a) shift the aggregate supply curve to the left.

a) an increase in worker productivity.

Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If there is a

Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. A general

Question 5) An economy is experiencing falling unemployment and deflation. This could be

a) a decrease in aggregate supply.

Question 6) An economy is experiencing rising unemployment and inflation. This could be

Moving from a short-run to long-run equilibrium