Question

1. Your research reveals these statistics for the economy of Fordhamatania:

Aggregate Demand AD = $425 (2) Maximum Output Y = $385

The average citizen will spend 80 cents for every $1 of gained income.

The economy is currently at equilibrium.

A) Aggregate Supply AS = ? (amount) Why?

B) What condition exists?

C) Corrective government spending = ? (amount)

D) Graph fully using the expenditures Approach.

E) Corrective tax policy = ? (amount)

F) Graph fully using the Leakages-Injections Approach.

G) Draw the chain diagram showing all the links in the process in part (E)

Your research also shows that a change in Money Supply Ms of $2B will change interest rate i by 2% AND a change in interest rate i of 2% will change Investment I by $4B.

H) Correct the problem using Monetary Policy MP.

I) Draw the chain diagram all the links in this MP process.

J) Given a Reserve Ratio rr = .10, what Fed Open Markets Operation corrects the problem.

Answer 1

A) Aggregate supply will be $425 because the economy is in equilibrium and as it is in equilibrium the aggregate demand must be equal to aggregate supply. If aggregate demand is $425 then aggregate supply must be $425 in equilibrium.

B) This is a short run equilibrium where aggregate demand is equal with aggregate supply but maximum output is $385. This maximum output is long run output and this output level is potential level of output. The equilibrium output in short run is $425. The short run actual output is more than potential level of output and this output gap is called inflationary gap.

C) The marginal propensity to consume is 0.8 as average citizens spend 80 cents per $1 gained income. As MPC 0.8 and we know the spending multiplier is 1/1-MPC. The value of multiplier with MPC 0.8 is 1/1-0.8 = 1/0.2 = 5. The multiplier value is 5. The inflationary gap is $425 - $385 = $40. So for long run potential level of equilibrium output there need to cut the spending by $40. Government expenditure should reduce by $40/5 = $8. It means total output change must be change in expenditure multiplied by spending multiplier. Here change in expenditure is -$8 and multiplier value is 5. So total change in output is -$8*5 = -$40. It means there will decrease in output by $40 and this change brings the economy in long run where current output is equal with potential output.