Answer:
1 Let's start with drawing the correctly labeled graph of aggregate demand (AD), short-run aggregate supply (SRAS), and long-run price level.
First, let's label the x-axis as Real GDP (output) and the y-axis as Price Level. Draw the AD curve sloping downwards from left to right, the SRAS curve sloping upwards from left to right, and the LRAS curve as a vertical line.
Now, let's label the current output as Q1, the current price level as P1, and the full-employment output level as FE.
To determine if the U.S. is currently experiencing a recessionary or inflationary gap, we compare Q1 with the FE level. If Q1 is less than the FE level, it indicates a recessionary gap. If Q1 is greater than the FE level, it indicates an inflationary gap.
For part C, we assume the current MPC (marginal propensity to consume) in the economy is 0.25.
To calculate the change and direction required in government spending to close the gap, we can use the formula:
Change in government spending = (1/MPC) * Change in Real GDP
Assuming we want to close the recessionary gap, where Q1 < FE:
Change in government spending = (1/0.25) * (FE - Q1)
For the change and direction required in taxes to close the gap, we can use the formula:
Change in taxes = -MPC * Change in Real GDP
Again, assuming we want to close the recessionary gap:
Change in taxes = -0.25 * (FE - Q1)
These calculations will give us the change in government spending and taxes needed to close the recessionary gap. If Q1 > FE and there's an inflationary gap, similar calculations need to be done with different signs to close the inflationary gap.
2
1. Draw a vertical axis representing the price level and a horizontal axis representing real output (GDP).
2. Draw the aggregate demand (AD) curve sloping downward from left to right, and the short-run aggregate supply (SRAS) curve sloping upward from left to right. The SRAS curve should intersect the AD curve to the right of the full-employment output level.
3. Label the AD curve as AD, the SRAS curve as SRAS, the full-employment output level as FE, the current output as Q1, and the current price level as PL1.
4. Draw a vertical line from the intersection of the AD and SRAS curves up to the price level axis to represent the gap above the full-employment output level.
5. Label the gap above as the output gap.
3
1. Effect of Government Spending and Taxes on Real Interest Rates:
- An increase in government spending or a decrease in taxes would lead to an increase in the demand for loanable funds, shifting the demand curve to the right. This would result in an increase in real interest rates. Conversely, a decrease in government spending or an increase in taxes would lead to a decrease in the demand for loanable funds, shifting the demand curve to the left, and subsequently reducing real interest rates.
2. Effects on Aggregate Demand and Unemployment in the Short Run:
- An increase in government spending or a decrease in taxes would increase aggregate demand, leading to a short-term decrease in unemployment. Conversely, a decrease in government spending or an increase in taxes would decrease aggregate demand, leading to a short-term increase in unemployment.
3. Self-Correction to Achieve Long-Run Equilibrium:
- In the absence of fiscal policy, the economy would adjust on its own to achieve long-run equilibrium through the mechanism of the interest rate. If the economy is in a recessionary gap due to decreased aggregate demand, the resulting lower interest rates would stimulate investment and consumption, eventually leading to increased aggregate demand and closing the output gap.
4. Effects on Price Level and Natural Rate of Unemployment:
- As the economy adjusts to long-run equilibrium, the price level would likely increase due to increased aggregate demand. The natural rate of unemployment should remain unchanged in the long run.
5. Advantage of Fiscal Policy over Self-Correction:
- One advantage of fiscal policy is that it can be implemented more rapidly and with more precision than relying on the self-correction mechanism of the economy. Additionally, fiscal policy allows policymakers to tailor specific changes in government spending and taxes to target specific sectors or demographics within the economy.