This is a closed economy. Wages are unable to adjust in the short run. At first,...

This is a closed economy. Wages are unable to adjust in the short run. At first, the economy equilibrium is at Y=Original, and P=Pe (the expected price level when managers signed contracts for nominal wages. This is a horizontal short-run aggregate supply curve.

Consider this: The government increased spending (G) by 215.

A) How will Investment (I) change in the short-run?

B) How will Consumption (C) change in the short-run?

C) How will Output (Y) change in the short-run?

D)How will Y change in the long-run?

E) How Will C change in the long-run?

F) How will I change in the long-run?

Expert Solution

Y= AD= C+I+G (closed economy)

A) In the short run, the increase in government spending will increase output and this in turn will increase investment through the marginal propensity to invest. Basically the multiplier effect is in effect and investment rise.

B) Consumption would increase in the short run due to the multiplier effect of the increased aggregate spending.

C)Output will rise in the short run in the first period by the amount of G=215. In the consequest periods(short run) there will be more increase in output due to the multiplier effect.

D)In the long run, wages are no longer sticky and there is a realization about the fall in real wages.This occurs after the old contracts are over and new contracts are to be signed. So wages are raised to sustain employment and production. However this rise in input prices by firm, have decreased aggregate supply. There is also a higher expectation of prices which increases costs and thus output will fall again and return to the original level of Y. Basically in the short run, sellers no longer face a horizontal aggregate supply curve as wages are flexible now.

E) In the long run, there will be a complete crowding out of consumption. The increased spending has increased prices and interest rates (in the the context of IS-LM model). Also output has returned to original so mpc decreases the amount of consumption.

F) Investments also completely crowd out in the long run, due to the increase in interest rates. There is a fall in the amount of investments due to fall in output as well due to the mpi.

Rahul Sunny answered 2 years ago

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