PROBLEM 1

In the country of Arcadia, the minimum amount of consumption spending that will occur in a given year is \$200 – that is, no matter what level of income households have, the aggregate amount of consumption spending in the economy will be at least \$200. In addition, for every extra dollar of national income, consumption spending will increase by \$0.60. (Note: For the entirety of this problem, assume that the aggregate price level in Arcadia is fixed.)

In 2019 in Arcadia, planned investment expenditure was \$200, there was no government spending or taxation or government transfers and no exports or imports.

2. If real GDP (i.e. value of all production in the Arcadian economy) in 2019 were \$800, what would be the level of planned Aggregate Expenditure? Would production be exactly equal to expenditure, or would suppliers have to reduce or increase inventories? If so, by how much? [TYPE YOUR ANSWER BELOW]
3. What was the income-expenditure equilibrium level of real GDP in Arcadia in 2019? Support your answer by filling in all of the blank cells in the table below.
 Real GDP Disposable Income (YD) Consumption (C) Planned Investment (Ip) Planned Aggregate Expenditure (AEp) Unplanned Investment (Iu) 700 800 900 1,000 1,100 1,200 1,300 1,400 1,500 1,600

1. Suppose that planned investment increased to \$400. Write out the new planned Aggregate Expenditure function. [TYPE YOUR ANSWER BELOW]

PROBLEM 2

1. Explain how the “wealth effect” causes the Aggregate Demand curve to be downward sloping. [TYPE YOUR ANSWER BELOW]
2. Explain how “sticky nominal wages” cause the Short-Run Aggregate Supply curve to be upward sloping. [TYPE YOUR ANSWER BELOW]
3. The table below lists a number of economic events. For each event, indicate
4. whether it will shift the AD curve to the right (by entering “R”), to the left (by entering “L”), or not at all (by leaving it blank);
5. whether it will shift the Short-Run AS curve to the right (by entering “R”), to the left (by entering “L”), or not at all (by leaving it blank)
• what will happen to equilibrium Real GDP as a result of the shifts (enter “+” for an increase, “-” for a decrease or “?” if the result is ambiguous);
1. what will happen to the equilibrium Aggregate Price Level as a result of the shifts (enter “+” for an increase, “-” for a decrease or “?” if the result is ambiguous)

The first entry is filled in for you. [FILL IN THE REMAINING ROWS, AS INSTRUCTED ABOVE]

 Events AD Shift S-R AS Shift Change in Eq. GDP Change in Eq. Price Level An increase in consumer optimism causes a rise in consumption R + + A nationwide, prolonged internet outage severely decreases worker productivity A sharp rise in the stock market increases consumer wealth The price of oil sharply decreases AND businesses decrease investment due to pessimism about the future A sharp rise in health insurance premiums requires employers to increase their workers’ overall compensation

1. Is the economy depicted in Figure 1 (on p. 6) experiencing an inflationary gap, a recessionary gap, or neither? Explain your answer. [TYPE YOUR ANSWER BELOW]
2. Assume that the government takes no action in response to the situation depicted in Figure 1. How will the economy adjust over time so that short-run equilibrium real GDP eventually equals potential real GDP? (Note: For full credit you must NOT ONLY indicate which curves will shift and in which direction, BUT ALSO what will cause the curves to shift.) [TYPE YOUR ANSWER BELOW]

PROBLEM 3

In the country of Borealis, the minimum amount of consumption spending that will occur is \$300 – that is, no matter what level of income households have, the aggregate amount of consumption spending in the economy will be at least \$300. In addition, for every extra dollar of national income, consumption spending will increase by \$0.75.

Planned investment spending in Borealis is \$100, and Government spending on goods and services is also \$100. Taxes, transfers, exports and imports all equal zero.

1. Write out the planned Aggregate Expenditure function for Borealis. [TYPE YOUR ANSWER BELOW]

The economic advisers to the President of Borealis calculate that Borealis’ potential real GDP is \$3,000. The state of Aggregate Demand and Aggregate Supply in the economy is depicted in Figure 2 on p. 6. The president informs her advisers that she would like to use expansionary fiscal policy to push the economy closer to its potential.

1. What is the value of the multiplier in Borealis? [TYPE YOUR ANSWER BELOW]
2. What are the three tools of fiscal policy the president could use to stimulate expenditure? In your answer, be sure to indicate which of the three categories of aggregate expenditure (i.e. C, I or G) each fiscal policy tool would primarily affect. [TYPE YOUR ANSWER BELOW]
4. Will the increase in government spending on goods and services to \$350 be enough to close the recessionary gap? Explain your answer, being sure to mention the significance of the upward-sloping short-run aggregate supply curve and the aggregate price level. [TYPE YOUR ANSWER BELOW]

Figure 1

Figure 2. Aggregate Demand and Aggregate Supply in Borealis

Table 1. For (optional) use with Problem 1 part (h)

 Real GDP Disposable Income (YD) Consumption (C) Planned Investment (Ip) Planned Aggregate Expenditure (AEp) Unplanned Investment (Iu)

Table 2. For (optional) use with Problem 3 part (b)

 Real GDP Disposable Income (YD) Consumption (C) Planned Investment (Ip) Government Spending (G) Planned Aggregate Expenditure (AEp) Unplanned Investment (Iu)

Table 3. For (optional) use with Problem 3 part (e)

 Real GDP Disposable Income (YD) Consumption (C) Planned Investment (Ip) Government Spending (G) Planned Aggregate Expenditure (AEp) Unplanned Investment (Iu)

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