Question

QUESTION B3

The figure below depicts aggregate demand and aggregate supply in the nation of Pacifica in 2018.

At the beginning of 2019, a wave of business optimism led producers to sharply increase their planned investment expenditure.

1. What effect, if any, will this increased investment expenditure have in the short-run on the Aggregate Demand curve? The Short-Run Aggregate Supply curve? [TYPE YOUR ANSWER BELOW]

2. After the increased investment expenditure, will short-run equilibrium real GDP be above or below potential GDP? How do you know? [TYPE YOUR ANSWER BELOW]

3. After the increased investment expenditure, if the government takes no action how will Pacifica’s economy adjust over time to move towards its long-run equilibrium? (Note: for full credit you must explain not only what happens to move the economy to long-run equilibrium, but also why it happens.) [TYPE YOUR ANSWER BELOW]

The president of Pacifica is concerned about the effect of this new investment expenditure on the economy, and she wishes to use monetary policy to move equilibrium GDP back toward potential GDP. (For the remainder of the question, assume that the Pacifica Central Bank is Pacifica’s version of the United States Federal Reserve and that Pacifica’s banking and financial systems work exactly like the United States’ banking and financial systems.)

4. Which one of the following policies would help the president achieve her aim? [TYPE YOUR ANSWER BELOW]

1. Direct the Pacifica Central Bank to sell Pacifica Treasury Bills
2. Direct the Pacifica Central Bank to purchase Pacifica Treasury Bills

The figure below represents the money market in Pacifica just after the increase in investment expenditure but before the government undertakes the monetary policy you chose in part (d).

5. Explain why the Money Demand curve has a negative slope. (Note: you must say more than that money demand increases as the interest rate decreases, and vice versa. You must explain why this is the case.) [TYPE YOUR ANSWER BELOW]

6. What effect (if any) will the monetary policy you chose in part (d) have (in the short-run) on the Money Supply curve? The Money Demand curve? The equilibrium interest rate? [TYPE YOUR ANSWER BELOW]

7. What impact (if any) will this monetary policy have (in the short-run) on Aggregate Expenditure? (If it does have an effect on Aggregate Expenditure, explain which component or components of Aggregate Expenditure will be most affected.) [TYPE YOUR ANSWER BELOW]

8. What impact (if any) will this monetary policy have on short-run equilibrium real GDP and the short-run equilibrium Aggregate Price Level? [TYPE YOUR ANSWER BELOW]

Answer 1

1. What effect, if any, will this increased investment expenditure have in the short-run on the Aggregate Demand curve? The Short-Run Aggregate Supply curve? [TYPE YOUR ANSWER BELOW]

The AD curve will shift out due to the higher investment. The SRAS curve will not be affected.

1. After the increased investment expenditure, will short-run equilibrium real GDP be above or below potential GDP? How do you know? [TYPE YOUR ANSWER BELOW]

The short run equilbrium GDP will rise becuse the AD curve will shift to the right.

1. After the increased investment expenditure, if the government takes no action how will Pacifica’s economy adjust over time to move towards its long-run equilibrium? (Note: for full credit you must explain not only what happens to move the economy to long-run equilibrium, but also why it happens.) [TYPE YOUR ANSWER BELOW]
   In the short run, the price level will rise. So in the long run, this higher price level wil be accounted for in the resource costs. As a result, the SRAS curve will shift to the left till full employmnet level of output is reached.

1. Which one of the following policies would help the president achieve her aim? [TYPE YOUR ANSWER BELOW]

1. Direct the Pacifica Central Bank to sell Pacifica Treasury Bills
   Explanation: Selling the bills would lead to lower money supply. As a result, the interest rate would rise and investment would fall.

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