Q 1&2

1. Consider the standard aggregate supply and demand model that is in long run equilibrium. a. Explain why the aggregate demand curve is downward sloping. b. Explain why the short run aggregate supply curve is upward sloping c. If there is an increase in consumer confidence in the economy, which component of spending is impacted, and how? d. Use a graph to illustrate the effect of increased consumer confidence on the spending you indicated in (c) [hint: do not draw AD/AS yet, draw a different graph that we discussed in class]. e. Use the AD/AS framework to illustrate the impact on the price level and real output when there is an increase in consumer confidence. Does this create an inflationary gap or recessionary gap? f. If this increased consumer confidence causes short run equilibrium output to differ from potential output by $500, and the MPC is 0.5, by how much should the government change spending in order to bring the economy to potential output? By how much should the government change taxes? What type of fiscal policy is this? g. On a new graph, draw the same effect from (d), but show the effect of the economy self-adjusting in the long run (assume the government does not intervene). Explain briefly the mechanism by which this occurs. 2. Consider the standard aggregate supply and demand model that is in long run equilibrium with price level P a. Give an explanation for the vertical shape of the long run aggregate supply curve. b. Using a graph, demonstrate the effect of a new education program that will increase human capital and labor productivity (hint: consider all possible shifts). c. What happens to the price level and real output in the long run assuming there are no shifts in aggregate demand? d. What additional demand-side fiscal policy, alongside the education program, could the government undertake if they wanted the price level to stay constant at Po? Show on a new graph why your suggestion would work.