Question

Problem 1

The economy has suffered decline in output due to Covid-19. To avoid the economy plunging into a deeper recession, the government introduced a stimulus bill whereby every individual would get cash.

i. How can such a stimulus bill be represented in our macroeconomic model?

ii. Using just the equilibrium model of output market (this is the graph with aggregate expenditure and the 45 degree line), show what happens to the equilibrium level of output.

iii. How is the IS curve affected by this new bill? iv. How is the AD curve affected by the bill? v. Now draw the AS and AD curves together and show the final effect on the level of output and overall prices.

vi. What is the effect of this change in price on the market interest rate. Explain this clearly.

vii. Does the market interest rate change? What is its effect on the investment level?

viii. What is the effect of the change in interest rate on the AE line? And, output?

ix. Compare your answer to (2) and comment on the importance of incorporating prices in the analysis.

Problem 2

Consumer confidence is also affected by the pandemic.

i. How does the Fed respond to this drop in consumer confidence?

ii. What is its effect on the AD curve, and aggregate output?

iii. How does the combined effects of the stimulus bill from problem 1 and the Fed’s response to the drop in consumer confidence affect aggregate output? Do these two policies cancel or augment each other?

Answer 1

Answer 1;

i. The stimulus bill will increase the level of government expenditure in the economy and also increase transfer payment from the government. This will increase income in the hands of people and thus increase the level of consumption expenditure in the economy. In the Keynessian aggregate expenditure model, the change will lead to increase in the level of aggregate expenditure in the economy.

ii.This can be represented on the outout market graph as follows:

iii. Increase in government exenditure and consumption expenditure in the economy will increase the level of aggregate expenditure in the economy and this will shift the IS curve of the economy rightwards.

iv. Increase in the level of aggregate expenditure will shift the aggregate demand currve of the economy rightwards. This is because aggregate demand is the sum of consumption expenditure, investment expenditure, government expenditure and increase in the two of these components will increase the level of aggregate demand in the economy.