Unit 7 Aggregate Demand Supply & Fiscal Policy Problem Set #7 PDF

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Aggregate Demand Supply & Fiscal Policy Problem Set...

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Unit 7 Problem Set #7 1. LMS 2. a. Aggregate Demand is demand for all goods and services. All prices and quantities are combined together into real GDP. The first reason why the Aggregate Demand curve is downward sloping is the real-balance effect where higher prices reduce the purchasing power of money which decreases the quantity of expenditures, and lower prices increase purchasing power and increase expenditures. The second reason is the interest rate effect which is when the price level increases, and lenders need to charge higher interest rates to get a real return on their loans. Higher interest rates discourage consumer spending and business investment. The third and final reason is the foreign trade effect which happens when the U.S. price level rises causing foreign buyers to purchase fewer U.S. goods and Americans to buy more foreign goods. Exports fall and imports rise, causing real GDP demanded to fall. b. The first shifter of Aggregate Demand is consumer spending such as household debt. The second shifter is investment spending such as productivity or technology. The third shifter is government spending such as infrastructure and programs, and the fourth shifter is foreign spending such as a trading partner’s economic health. c. Aggregate Supply is the amount of rGDP firms will supply at different price levels. It is the supply of everything by all firms added up. In short run, if prices rise, businesses will not face higher resource and wage costs. Higher prices equal more profit, so higher AS. In long run, eventually all these higher prices make their way back to consumers and workers, who demand higher wages. In the long run, higher prices do not lead to more rGDP.

d. The first shifter of Aggregate Supply is Inflationary Expectations, which is when an increase in AD leads people to expect an increase in prices in the future, so they decrease supplying now in expectation of future increase. The second shifter is Resource Prices, which is important because if resources cost more, less money will be spent on products because it would cost more to acquire resources. The third shifter is Productivity, which is when technology advances or there is a power outage.

e. Inflationary Gaps happen when the quantity being produced is greater than the quantity produced at full employment. For example, if the government cuts taxes on companies, which would raise AD. The economy returns to the long run as people demand more money and thus lowering AS.

f. Recessionary Gaps happen when the quantity being produced is less than the quantity produced at full employment. For example, if one of the United States’ trading partners had a severe recession and thus lowering AD. The economy returns to the long run because people are willing to work for less money instead of no money at all; this lowers AS.

3. a. Long-run economic growth can be enabled by increases in productivity, which are short-run shifts in AS. This occurs because they have long lasting effects and will shift LRAS to the right. The government can enact discretionary fiscal policy and pass new bills, such as tax cuts for corporations, or they can utilize non-discretionary fiscal policy, such as welfare which is already established in bills that have already been passed as laws. b.

a. The point labeled A is when there is an inflationary gap on the AD/AS graph, and the point labeled B is when there is a recessionary gap on the AD/AS graph.

b. The two graphs are mirror images of each other. When there is an inflationary gap and AD increases, the point moves to the left on the SRPC.

5. a. Fiscal Policy is the action government takes to help fix or change the economy. The two types of fiscal policy are discretionary fiscal policy, which is new legislation, and nondiscretionary fiscal policy, which is enacted previously established legislation. This policy shifts AD. Laissez Faire Policy is where you let the economy fix itself, and this policy shifts AS. b. The first problem with fiscal policy is Time Lags and Inefficiency, which happens because writing and passing bills takes time. The second problem is Rational Expectations Theory which states that more government spending now will lead to future tax increases meaning that government spending and tax cuts will require future tax increases, so it is better to spend less now and save up, which would lower AD. The third problem is Crowding-Out-Effect where government spending can reduce or “crowd-out” investment or consumer spending. For example, if the government spends money to build a new public library, AD would increase, but consumers would buy less books which would decrease AD. The fourth problem is the Net Export Effect where international trade hampers fiscal policy.

c. The spending multiplier effect occurs when the government spends money, and the money gets multiplied through the economy depending on how much consumers spend and save. If MPC = 0.4, then MPS = 1 – 0.4 = 0.6 and 1 1 = =$ 1.67 . The tax multiplier is one less spending multiplier = MPS 0.6 than the spending multiplier because tax cuts have less of an impact on AD than spending does, since people save some of the tax cuts. If the spending multiplier is $1.67, then the tax multiplier = $1.67 – $1 = $0.67....