Question

Use the ADAS model to graph the following events involving fiscal policy. Note: Don't confuse the ADAS model with the supply and Demand model or the Market for Loanable Funds 1. Consumer spending falls, and then the government increases purchases, which quickly returns RGDP and Price Level to its original levels. Hint: Equilibrium points a,b,c or 1,2,3. Question to answer: What is the long-run effect (compare beginning to end) on the price level and national income? 2. Investors become pessimistic, and then the government gives everyone $4,000, which temporarily raises RGDP above its original level. Hint: This is "overshooting" policy Question to answer: What is the long-run effect (compare beginning to end) on the price level and national income?

Answer 1

LAAS SRAS Price 1-3 P to AD ADI PRGDP y* LRAS 个 Overshooting SRAS Price. 3 Tui АР, AD AD RGóp * y* Yg

1.

We know that Aggregate Demand (AD) equation is written as:

AD = C + I + G + NX

whrere C = consumption spedning

I = Investment spending

G = Government spending

NX = Net Exports

REFER TO 1st FIGURE

Initial equilibrium is at point 1 where LRAS, SRAS and AD curve intersect. Equilibrium RGDP is Y* and price level is P.

Fall in the consumer spending will decreases the Aggregate Demand. The AD curve will shift left from AD to AD1. There will be downward movement along the SRAS curve from point 1 to 2. Both Price level and RGDP falls and the economy experiences Recessioanary Gap.

Increase in the government purchases will increase the "G" component in AD equation. This will shift the AD back to its initial level. Economy again reaches to the initial equilibrium point 1. Full employment is restored at Y* and the price level shoots up to P.

Long run effect: Both RGDP and Price level reached to their initial position. No change.

2.

REFER TO 2nd FIGURE

Fall in the investors confidence will reduce the investment level and impact the "I" component of the AD equation. The curve shifts left from AD to AD1. There is a downward movement along the SRAS curve from point 1 to 2.

Rise in the government spending, in the short run, will increase the AD curve over and beyond the initial AD curve. This is when government spends money more than what is sufficient to reach full employment. AD curve shifts up from AD1 to AD2. Price level shoots up from P1 to P2 and the Real GDP increases to Y2. At Y2, economy experiences Inflationary Gap.

Long Run effect: Both Price and RGDP increases.

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