Question

There is a surge of optimism, and firms start to increase their investment at an irrational rate.

1. Use a graph and determine the short-run effects on the price level (P) and real output (Y).

We assume that the government will take no deliberate action.

2. With time, what will happen to expected price level?
3. Based on (b), what will happen to the short-run aggregate supply curve?

We now assume, instead, that the government decides to intervene immediately instead of waiting for the economy to self-correct. The government can stabilize output through monetary policy or fiscal policy.

4. How should the Fed adjust money supply and interest rate to stabilize output? Use a graph to illustrate how that works.
5. List two possible fiscal policies to stabilize output.

Answer 1

Suppose in short run economy is initially equilibrium at point A where aggregate supply curve and aggregate demand curve intersects at P level of price and Y level of real output. If an investment in economy increases, it would increase the productivity of economy. As a result aggregate supply of good and services will increase. It will shift the AS curve rightward as AS1. Price level falls to P1 and real output increases to Y1.
But increase in investment will cause aggregate demand of good and services in the economy. Because higher level of investment rises the employment level in the economy. Thereby it increases the income level of economy. It will increase the aggregate demand in the economy. So aggregate demand in the economy increases in long run. It will increases the expected price level in the economy.
In long run long run aggregate supply curve will remain vertical. Price level does not affect the real output. Increase in aggregate demand causes rise in general price level. It will cause inflation in the economy
During inflationaru situation, government will implement contractionary fiscal policy in the economy
The two types of contractionary fiscal policies are
1. Reducing government spending
2. Increasing tax rates
By reducing government spending and increasing tax rates, private investment will reduce. Thereby it reduces consumption level due to fall in income level in the economy. Therefore aggregate demand will reduce in the economy. Economy will be reaches to previous equilibrium.
Fed will reduce the money supply by rising interest rates. It will reduce investment due to increase in cost of borrowing. Thereby it reduces aggregate demand in the economy