IN-CLASS EXERCISE #8

An economy is in long-run macroeconomic equilibrium when each of the following aggregate demand shocks occurs. In the long run the economy is self-correcting through changes in nominal wages but if policy makers react quickly they can use fiscal policy to shift the demand curve back much sooner. Read each statement and answer the questions that follow:

A stock market boom increases the value of stocks held by households.

What kind of gap is created? Inflationary or Recessionary

What type of fiscal policy would help move the economy back to potential output (Yf)?

How would your recommended fiscal policy shift the AD curve?

Businesses come to believe that there will likely be a recession in the near future.

What kind of gap is created? Inflationary or Recessionary

What type of fiscal policy would help move the economy back to potential output (Yf)?

How would your recommended fiscal policy shift the AD curve?

The government is debating whether to increase government spending (G) or reduce taxes (T) to stimulate the economy. (mpc = .8 and z = .5)

Using the multiplier (1/1-z) what will be the change in Y if the government increases spending (G) by $2M?

Using the tax multiplier (-mpc/1-z) what will be the change in Y if the government decreases taxes (T) by $2M?

Which policy change will have the greatest impact on GDP?