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EC 100 Macro Exercise 4 (AS-AD)

EC 100 Macro Exercise 4 (AS-AD). Question 1. Describe if the following will shift the aggregate demand curve or the aggregate supply curve, and if so in which direction:) an increase in government spending) shifts IS right, hence AD right

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EC 100 Macro Exercise 4 (AS-AD)

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  1. EC 100Macro Exercise 4(AS-AD)

  2. Question 1 • Describe if the following will shift the aggregate demand curve or the aggregate supply curve, and if so in which direction:) • an increase in government spending) shifts IS right, hence AD right • (an increase in the supply of money) shifts LM right, hence AD right • (a tax cut) shifts IS right, hence AD right • (an increase in bank reserve requirements) reduces money supply, therefore shifting LM left, and hence AD left • (an increase in nominal wages) increases costs, hence shifts AS upwards • (an increase in labourproductivity) increases output at a given price, hence shifts AS right • If you prefer, can think of increase in productivity as reducing cost • Note that the full employment level of output is now higher

  3. Question 2 • Describe the effects on (i) output, (ii) employment, and (iii) the price level of: • an increase in government spending financed by bond sales (i.e., deficit financing) • IS shifts to right; no change in money supply, hence no shift in LM. Thus AD shifts to right. Fiscal policy is expansionary but (with the typical LM curve) there will be some crowding out.

  4. Question 2 • Note what is happening behind the scenes… • Let’s think in terms of Q (real GDP). Suppose the government wants to increase Q by increasing G. Seems reasonable… • There are now two sources of “crowding out” if G increases: • The rise in r due to increase in Money Demand (from IS-LM classes) • The rise in r due to the rise in P, which reduces real money supply • We are seeing that G is less effective in increasing output than we first thought!

  5. Question 2 • Describe the effects on (i) output, (ii) employment, and (iii) the price level of: • an increase in the money supply • LM shifts right, hence AD shifts right. With the typical IS curve, the effect is expansionary. • Recall: if I does not depend on r, the IS curve is vertical, and changes in money supply do not affect output

  6. LM(M0,P0) LM(M1, P1) LM(M1, P0) r0 r1 r2 IS(G0) QA QB We would only end up at Qb if the price didn’t change. But it increases, so we end up at Qc. AS P1 P0 AD(M1) M1 > M0 AD(M0) QA QB QC

  7. Question 2 • Describe the effects on (i) output, (ii) employment, and (iii) the price level of: • an increase in government spending financed by an increase in money supply • IS and LM shift right • The LM movement reduces the interest rate increase (hence reducing/eliminating the first source of crowding out above) • hence more expansionary than either a. or b. • AD shifts right.

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