Economics Micro & Macro (CliffsAP)

Mini-Review Answers

1. B.When investment is added to the expenditures model, it increases the level of expenditures in the economy.
   Firms use investment to create capital, and this in turn creates employment.


2. C.The 45-degree line represents a point of equality between the vertical and horizontal axes. On the aggregate
   expenditures graph, the vertical axis shows consumption/expenditures, and the horizontal axis represents GDP.


3. A.When more expenditures are added to the graph, the result is a new equilibrium. No equilibrium is fixed
   because levels of expenditures may change.

Aggregate Demand

The forces of supply and demand are also used on a national and international level. Earlier in our review, we touched
on supply and demand and the determinants that shift both curves. Let’s now focus our attention on aggregate supply
and aggregate demand, the forces that dictate GDP for our economy.

Aggregate demand represents the amount of real output that buyers collectively desire to consume at each price level.
On the vertical axis of an aggregate demand curve, we have the price level, which represents the average of the total
prices in a market basket. On the horizontal axis, we have the quantity of real GDP. GDP and price level are inversely
related on this graph. When the price level rises, the quantity of real GDP demanded falls; when the price level falls,
the quantity of real GDP demanded rises.

Figure 4-2 illustrates an aggregate demand curve. At first glance, it may seem identical to an individual firm’s demand
curve; however, this is not the case. The price level represents prices in the whole economy, whereas quantity represents
the amount of real GDP demanded in the whole economy.

Figure 4-2

If this curve is different from an individual firm’s demand curve, then what is the reason for the difference? The answer
rests on three effects of a price-level change: the real-balance effect, the interest-rate effect, and the foreign-purchases
effect.

■ The Real-Balance Effect:A change in the price level diminishes the public’s purchasing power. If a family is plan-

ning on buying a home, they will likely reconsider that purchase if inflation erodes the value of their purchasing

power. A higher price level translates into less consumption spending.

Price

Level

Real GDP

AD

Aggregate Expenditures, Aggregate Supply and Aggregate Demand Models