Question

In this question, we assume the city of Oshawa is a closed economy and is in its long-run equilibrium. Recently, General Motors (GM) announced that the company will stick to its plan that they will close their automobile assembly plant in the city this year.

a) According to the long-run classical model, what happens to the equilibrium levels of output, real interest rate, and investment in Oshawa after the plant closure? What happens to the real wage in Oshawa? Explain your answer with the aid of TWO diagrams – one for the loanable funds market and one for the labour market.

b) In addition to the direct impact of the GM plant closure on the economy, many expect jobs that are related to the assembly plant will also be affected. As a result, the incentive to conduct business in Oshawa falls.

• Explain in words, what happens to autonomous investment?

• With the aid of the loanable fund market diagram drawn in part (a), explain the effect of the change in autonomous investment on the real interest rate.

Note: DO NOT draw a new diagram; if you do so, you will not receive any credit for this part of the question.

• As time passes (i.e., in the very long run which will be 10-15 years from now), what happens to the stocks of productive inputs in Oshawa? What happens to the level of employment in Oshawa? Explain in words only. (4 points)

Answer 1

a) According to the long-run classical model, what happens to the equilibrium levels of output, real interest rate, and investment in Oshawa after the plant closure? What happens to the real wage in Oshawa? Explain your answer with the aid of TWO diagrams – one for the loanable funds market and one for the labour market.

The given condition is that economy is at full potential. When a plant closes down then it will go in deflationary gap in the short run wherein it will produce less than its potential. Aggregate demand curve shifts left. This will decrease average price levels from P1 to P2. As unemployment increase demand for money(loanable funds) will go down and hence interest rates will also go down. As economy is producing less labor demand will also go down and wage rates will go down according to monetarists.

Figure 1 shows demand for loanable funds going down and hence interest rates go down from i1 to i2.

Figure 2 shows that as demand for labors shifts left wages go down from w1 to w2.

b) In addition to the direct impact of the GM plant closure on the economy, many expect jobs that are related to the assembly plant will also be affected. As a result, the incentive to conduct business in Oshawa falls.

• Explain in words, what happens to autonomous investment?

Autonomous investment is an investment in a country that is made without regard to the level of economic growth. GM plant closure will increase autonomous investment as government has a goal of improving societal welfare.

• With the aid of the loanable fund market diagram drawn in part (a), explain the effect of the change in autonomous investment on the real interest rate.

As autonomous investment increases then as demand for money increases and demand shifts from D2 to D1, interest rates increase from i2 to i1.

•As time passes (i.e., in the very long run which will be 10-15 years from now), what happens to the stocks of productive inputs in Oshawa? What happens to the level of employment in Oshawa? Explain in words only.

In the long run, according to monetarists economy will achieve equilibrium at full potential. This happens because in the short run as economy was in recessionary gap, factors of production prices went down including wages went down. This incentivices producers to produce more. Shift in aggregate supply to right will bring economy to full potential at a new price level. In the long run of 10-15 years, if economy produces at full potential and there is investment in human capital economy potential output may shift to right and economic growth rate may also increase.