Consider the AD/AS model of the economy built from the IS/LM, and assume that th

Question

Consider the AD/AS model of the economy built from the IS/LM, and assume that the SRAS is upward sloping. The economy is currently operating at the full employment level of output. Assume that the MPC in this country suddenly decreases from 0.8 to 0.5, but fiscal policy and monetary policy do not change in response to this increase.

1. What are the short-run effects of the decrease in the MPC?

a. The real interest rate will decrease and output will increase.
b. The real interest rate will be unchanged and output will decrease. c. The real interest rate will decrease and prices will increase.
d. Output will decrease and prices will increase.
e. Output will decrease and prices will decrease.

2. What are the long-run effects of the decrease in the MPC?

a. Prices and output will both be higher than in the original long-run equilibrium.
b. Prices will go back to their level in the original long-run equilibrium, but the real interest rate will be lower than in the original long-run equilibrium.
c. The real interest rate will be lower than in the original long-run equilibrium, and output will return to its potential level.
d. The real interest rate and output will both be lower than in the original long-run equilibrium.
e. The real interest rate will be lower than in the original long-run equilibrium, but prices will be higher.

Explanation / Answer

1. As the MPC is decreased, consumption reduces, which means people will tend to save more. When savings are going up, demand for goods decreases and prices will also decrease.Option E.

2. In order to bring back the prices to equilibrium level, the real interest rate continues to be low so as to boost the demand. Option B.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.