These brief answers are meant to give students an idea of whether or not they are on the right track.  Generally, student answers should be longer and more complete.

1.  Explain why the aggregate demand curve is downward sloping.

• Wealth Effect
• Foreign Sector Substitution Effect

2.  List two different types of changes that could cause a decrease in AS.

• Increased factor costs
• More, or less efficient, government regulation

3.  Why is the shape of the aggregate supply curve an important issue with regard to macroeconomic policy? What would Keynesians argue is the likely shape of the AS curve? What would classicals argue is the likely shape of the AS curve?

• The slope of the AS determines whether fiscal stimulus can help boost the economy and create jobs or just cause inflation.  If the AS is very steep, increased AD will lead to inflation with little expansion in incomes and output.  If the AS is very flat, increased AD will lower unemployment and raise incomes and output with little change in prices.
• Classical economists focus on a long-run AS curve that is vertical at the full-employment level of income.

 4.  If the MPC is 0.75, what is the MPS? What is the multiplier?

• MPS = .25; (Autonomous spending) Multiplier =  4

5.   Assume AE = C + I. Also assume that autonomous consumption = $40 the MPC = 0.95 and I = $1000.

• What is the equation for this line (i.e., the aggregate expenditure function)?
  • AE  = 40 + .95Y + 1000 
• What is the equilibrium level of output & income? 
  • Y = 1040 + .95Y
  • .05Y = 1040
  • Y =  20800
• How much Consumption is desired at this level of income?
  • C = 40 + .95 (20800)
  • C = 19800
• What is the equation for the line showing how savings is affected by income? (Hint: The vertical intercept is not equal to autonomous consumption and the slope is not the MPC, but these two numbers do give you all the information you need.)
  • S = -40 + .05Y
• How much savings is desired at the equilibrium level of income?
  • S = -40 + .05(20800)
  • S = 1000
• How does savings compare to investment?
  • S = I
  • In a simple AE model with not government or foreign trade,  equilibrium occurs where savings equals investment.  That way, every dollar that consumers don't spend is eventually spent by  business instead.  That insures output equals expenditures, so inventories stay the same, money keeps flowing around the circular flow, and their is no need to change output or employment levels.

6.   Assume AE =  C + I + G and that autonomous consumption = $50, the MPC = 0.8,   G = $500, and I  =  $250.

• Write the equation for this line (i.e., the aggregate expenditure function).
• AE = 500 + 250 + 50 + .8 Y  =  800 + .8Y
• What would be the equilibrium level of output?
• 800 + .8Y = Y
• 800 = .2Y
• Y = 4000;  i.e. aggregate spending, output & income = $4000
• Assume the full-employment level of output is $5000, how much aggregate expenditure would we expect at this level?  Would there be a recessionary gap or an inflationary gap?  How large is this gap?
• calculate AE at the full employment level of output & income:
  • 800 + .8(5000) = $4800
• calculate difference between output and AE:
  • 5000 - 4800 = 200
• output exceeds expenditures by $200; there is a recessionary gap of $200
• If the government wanted to correct this policy by changing taxes, what would a Keynesian recommend?
• Since there is a recessionary gap, a tax cut is called for.
• Since the MPC = .8, households will only use 80% of the tax break to increase consumption.  To close a recessionary gap of $200, the tax cut will have to be larger than $200
• .8T = $200
• T = $250; a $250 tax cut is needed
• The multiplier for a tax cut is one less than the multiplier for an increase in government spending. In this case, the $250 tax cut would increase income & output by $1000 and bring the economy to full employment.
• If the government wanted to use changes in government spending, what would a Keynesian recommend?
• Government could increase spending by $200; this would close the recessionary gap.
• Using the multiplier, 1/(1-MPC) = 5,  we can see that this $200 increase in spending will increase aggregate income & output by $1000--exactly enough to make up the difference between the current equilibrium level of output ($4000) and the full-employment level ($5000).

7.   Here's an example with different numbers, your answer should look similar.  If the reserve requirement was 5%, the potential money multiplier would be 20.  Assume you deposit $100 into a bank and that the required reserve ratio is 20%. Use T-accounts to explain how the banks can use this money to create more money?
 
 

You deposit $100 into a checking account at first national bank. The $80 in excess reserves can be lent out; the lending of excess reserves is how money is created. The money supply is $100.	1st National Bank Assets Liabilities RR: $20 $100 (your checking account) ER: $80 Total: $100 Total: $100
1st National Bank lends $80 to Bill by creating a checking account for him & putting $80 into this account. Money Supply is now $180.	1st National Bank Assets Liabilities RR: $36 $100 (your checking) IOU from Bill: $80 $80 (Bill's checking) ER: $64 Total: $180 Total: $180
Bill uses $80 to buy bike from Sue. Sue deposits $80 in her checking account at 2nd National Bank. Money Supply is still $180 but 2nd national can lend out their excess reserves and thereby increase the money supply.	1st National Bank Assets Liabilities RR: $20 $100 (your checking) IOU from Bill: $80 Total: $100 Total: $100   2nd National Bank Assets Liabilities RR: $16 $80 (Sue's checking) ER: $64 Total: $80 Total: $80
2nd National Bank lends $64 to Juan by creating a checking account for him & putting $64 into this account. Money Supply is now $244 The $51.20 in excess reserves is available to lend out and increase the money supply even more. The money multiplier is 1/rrr = 1/.2 = 5. If this process continues, the $100 you deposited could and all the increases to the money supply could add up to $500.	1st National Bank Assets Liabilities RR: $20 $100 (your checking) IOU from Bill: $80 Total: $100 Total: $100   2nd National Bank Assets Liabilities RR: $28.80 $80 (Sue's checking) IOU from Juan: $64 $64 (Juan's checking) ER: $51.20 Total: $144 Total: $144