1. from a position of longterm equilibrium (P.O), the business sector decides th
ID: 1204671 • Letter: 1
Question
1. from a position of longterm equilibrium (P.O), the business sector decides that times have been so good that they will invest more. Assume that the change in investment is $80B and the MPC is .8
a. Using PAE/RGDP and AD/SRAS analysis, show th eimplications and $ of this increase.
b. in order to undertake policy action, what information do decision makers need?
c. what does the active policy guy say?
d. what does the passive policy guy say?
e. give me three examples of what policies might help fix the "problem", defining them as fiscal or monetary?
f. what could go wrong? variable estimation errors? time lags?
g. How much impact on AE must you have? Use all appropriate graphs to show the impact
Explanation / Answer
1) When investment rises by $80 billion, income rises multiple times, precisely by the amount 1/(1 – MPC). This, in turn, suggests that income will rise by 1/0.2 or 5 times to reach $400 billion
This stimulates the Aggregate expenditure AE, and with that the IS shifts to the right exhibiting a rise in income. With more income, the quantity of money demanded increases with fixed money supply. Hence the interest rate rises and both money market and goods market achieve a new equilibrium where both interest rate and income level are higher. With higher interest rate, investment spending falls. Consumption rises as income rises.
Since for the given price level, output rises, there is a rightward shift of the AD in AD-AS model.
2) Since policymakers realize that economy is going to expand, they need information about future inflationary expecatations, domestic market responsiveness to any change in the price and interest rates etc.
3) From the perspective of an individual, a policy’s activeness or passiveness play a crucial role in framing its future expectations. When the policies adopted have successfully insulated the economy, in that case government policy is active (rather pro-active). So the active policy guy will argue for contractionary fiscal policy and bringing the AD back to its original level.
4) It may happen that the government policy is inapt on the account of fluctuating output and employment. And therefore there is a case for passive policy. The passive policy guy will argue for patiently wait till the new equilibrium is reached. Then he will analyze the situation and argue for a policy decision.
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