Question

5)Right now, the market for loanable funds operates at equilibrium and interest rates are perfectly flexible. If I suddenly save $50,000, how much of that $50,000 will be borrowed? For this question, assume this market always operates at equilibrium.

a.All $50,000 will be borrowed

b.Between $0 and $50,000 will be borrowed

c.$0

6)If the market for loanable funds operates exactly as described in question 5, will Say’s Law hold? Explain your logic.

7)Why did the Classical Economists focus on the SRAS instead of the AD when considering how the economy fixes itself? Explain.

8)Explain the concept of “menu costs”. If menu costs are present, how does this affect the assumptions of the classical model? Be specific

Answer 1

Q5) The market for loanable funds is already at the equilibrium, with the demand and supply of loanable funds intersecting at the equilibrium interest rate. Now, as the supply of savings increase, the funds from aggregate savings are eventually borrowed, converted into investment expenditure, which is a component of aggregate demand .e. real GDP, so equilibrium may be maintained in the long run.

But in the short run,when 50,000 is suddenly saved, the funds from aggregate savings wll exceed the demand/needs of all the borrowers/investors in the economy. In this case, equilibrium will be affected and the real GDP will fall from the natural level, and the interest rate will fall as demand will be less than supply.

However, as it is said that the market is always operating at equilibrium i.e. the investment expenditure has to be equal to the level of aggregate savings,  and the equlibrium can't be affected, so, the sudden increase in savings will get converted entirely, and will get borrowed. So, if level of aggregate savings increase by 50,000, the level of investment spending also has to increase by the same amount, to maintain equilibrium. This takes place by the decreasing in the interest rate. The fall in the interest rate will increase the demand for available savings, restoring supply = demand. Economy will return back to the natural level of real GDP. So, all of 50,000 will get borrowed. So, correct option is (a). Take a look at fig 1.

Q6) Say's Law states that when an economy is producing a specific level of real GDP, it also generates the level of income which is needed to purchase that level of real GDP, so that the economy is always capable of demanding all of the output which the workers and firms decide to produce. So, the economy is always capable of attaining the natural level of real GDP. However, when a part of income is saved, it is not spent on consumption, the aggreagate demand will reduce than suply, leading to the equilibrium level of real GDP falling from the natural level. However, the classical economists believe, that these aggregate savings are then borrowed and enter the investment spending component of AD/GDP , thus increasing the GDP back to the natural level.  In the above example, we see that when the savings are suddenly increased, i.e. the supply of funds of aggregate saving exceeds the investment spending demand, the real GDP falls from the natural level. But, because of the flexible interest rates, they come down, increasing the demand for investment by the increased amount of savings, helping the economy get back to the natural level of real GDP. So, this flexible nature of interest rates is the self-adjusting mechnism of the Classical theory and maintains the natural level of real GDP, based on Say's Law and Flexible interest rates. So, YES, Say's Law does hold in this case.

Q7) Now, according to the Classical Economists, shocks are important in the short run, but not in the long run. The self-correction mechanism is all about prices and wages adjustment, the flexibles, interest rates, prices and wages adjust in the long run, to bring back the economy into equilibrium. The self-correction adjustment is focused on the resources and resource prices and the amount of output that a country produces/real GDP ultimately depends on the stock of resources. The LRAS is vertical at full employment level. Now, shifts in AD is caused due to changes in consumption, changes in planned investment spending, changing in govt spending and net exports. The shifts in SRAS are caused due to changes in expected inflation, prce shocks and persistent output gap. So, the changes in wages and other resources prices cause the shifts in the SRAS which helps to close any recessionary gap with lower wages. Temporary imbalances in the reource market are eliminated through flexible prices, wages etc. , causes changes in production costs, which causes shifts in SRAS until that intersect both the AD and LRAS at the long run equilibrium level. So, resource market imbalances are rectified. So, this is how the economy fixes itself by movements in the SRAS. Changes in SRAS is the driver of self-correctiom mechanism , and as the resource and output prices adjust to the shifts in the inflation rate and unemployment, SRAS shifts accordingly to close the output gap.

As per rules, need to answer the first question, have answered three! Thank you!