Question

Assume that the economy is at full employment. Now suppose a decrease in investment spending. At the new equilibrium,   (3)

1. will there be an output gap? What type? ________________________________

2. what is the effect on the price level? ___________________________________

3. what is the effect on the level of Real GDP? _____________________________

Assume that the economy is at full employment. Now suppose there is an increase in consumption. At the new equilibrium,

1. will there be an output gap? What type? ________________________________

2. what is the effect on the price level? ___________________________________

3. what is the effect on the level of Real GDP?______________________________

Answer 1

1. When assuming the economy is at full employment at the new equilibrium condition and when there is decrease in investment spending,  

a. Output gap will takes place. Such output gap will be in the form of Deflationary gap.

b. The Price level will decrease.

c. The rate of real GDP will be lesser than the potential GDP.

Reason:- All though when economy has the situation of full employment, sudden change of decrease in the investment leads to less production of goods and services with lesser quantity. Then price level falls as it was required to dispose the lagging stock as purchasing power of the consumers also decreases. Then the rate of real GDP goes to very lower level than the potential output because of collective evil effects of less quantity produced and the price level.

2. When assuming the economy is at full employment at the new equilibrium condition and when there is increase in consumption.  

a. Output gap will takes place. Such output gap will be in the form of Inflationary gap.

b. The Price level will increase.

c. The rate of real GDP will be greater than the potential GDP.

Reason:- All though when economy has the situation of full employment, sudden change of increase in the consumption leads to more production of goods and services with more quantity. Then price level shoots up as it was required to meet the requirement of increased demand of the goods and also with the effect of purchasing power of the consumers also increases. Then the rate of real GDP goes to high level than the potential output because of collective positive effects of more quantity produced and the increase in the price level.