1. The economy of Vanderlandia is in short-run equilibrium with a real GDP of $500m. The full-employment level of RGDP is $550m.
A) Draw a correctly label graph (CLG) of the aggregate demand, SRAS and LRAS curves showing,
(i) The current equilibrium real output (RGDP - Y1) and Price level (PL1).
(ii) The full employment output, labeled Yf.
(The economy is in a recession gap as the current equilibrium (Y1 - $500m)
has less output than the full employment equilibrium at (Yf - $550m)
B) Assume no policy action is taken to restore to full employment.
(i) Explain how the economy will adjust in the long-run.
(ii) Following the long-run adjustment process, will the price level in Vanderlandia be greater than, less than, or equal to PL1, shown in part (a).
This is a Classical View question. How do we know?
It says that there are No Policy Actions - which implies there is no fiscal or monetary policies
The economy must fix itself in the long-run
"and we answer it the same way every time."
If we are in a recessionary gap this implies that many people are out of work and will take lower wages to go back to work and input prices are falling due to a recession.
Lower wages and lower input costs for business will shift their SRAS curve to the right.
This lowers the price level (PL) and increases output back to the full employment level at a lower PL
Let's explain it tightly.
(i) In a recessionary gap people will accept lower wages and input prices are falling. Lower wages and lower input prices will shift the SRAS curve rightward until full employment is achieved at a lower price level in the long-run.
(ii) The PL will be less than PL1 in the long run. (No explanation needed)
C) Assume instead that policy makers in Vanderlandia are considering changing government spending to restore full employment in the short run and the marginal propensity to save is 0.2.
(i) Calculate the minimum change and state the direction of change in government spending required to completely close the output gap in the short-run. (Show your work)
(ii) On your graph in part (a), show the short-run effect of the change in government spending
in part (c)(i), labeling the new equilibrium price level PL2.
(i) If the MPS is 0.2 we find the spending multiplier with the formula 1/MPS and 1/MPS = 5
When government spending increases it will increase the RGDP/Outputs by a multiple of 5
If we remember we needed 50million to close the output gap back to full employment, so if the government spends 10million the money will multiply through the economy and give us the needed 50million increase in RGDP/output
10m x 5 = 50m
GS increase x Multiplier = increase in RGDP
(ii) If in a recessionary gap and the government starts spending it pushes the AD curve to the right toward full employment. Output increases to full employment (Yf)
the PL increases a higher level at PL2.
D) Draw a correctly labeled graph of the loanable funds market, and show the effect of the change in government spending in part (c)(i) on the equilibrium real interest rate.
When government spends it has to borrow from the loanable funds market
it takes money out of the banks & this reduces the supply of loanable funds
RIR's increase
E) Based on the change in the real interest rate (RIR), what will happen to each of the following.
(i) The price of previously issued bonds
Understand that interest rates and previously issued bond's prices are inversely related
RIR increases and bond prices decrease
(ii) The rate of economic growth in the long-run. Explain.
We answer these questions the same every time.
As RIR's increase there will be less investment & less capital formation
and therefore less LR Growth
