Question

An economy is producing output that is $400 billion less than the natural level of output, and fiscal policymakers want to close this recessionary gap.

• Draw a graph of aggregate demand and aggregate supply to illustrate the current situation. Be sure to label both the original equilibrium point and the new point, where the economy is in recession.
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• What is the correct fiscal policy for this scenario? If the marginal propensity to consume is 0.75, how much will the government have to spend to close the gap (assuming no crowding-out effect)?
• The central bank agrees to adjust the money supply to hold the interest rate constant, so there is no crowding out. Explain in your own words why this is necessary.
• Suppose fiscal policymakers are worried that they have misestimated the marginal propensity to consume, and spend an extra $100 billion more than what you computed in b). On the same graph as in part a), illustrate what will happen as a result of this fiscal action.
• If no additional fiscal or monetary action is taken, what will this economy look like in the long run? HINT: adjust the short-run aggregate supply curve so that it intersects with the long-run agg. supply curve and the latest agg. demand curve. This intersection point is your new long-run equilibrium. What has happened to prices and quantities in the long run?

Answer 1

Here is a brief summary of the main points:

• To illustrate the current situation, we draw a graph of aggregate demand and aggregate supply, with the original equilibrium point labeled as A and the new point, where the economy is in recession, labeled as B.

• The correct fiscal policy for this scenario is expansionary fiscal policy, which involves increasing government spending or reducing taxes to increase aggregate demand. To close the gap, the government will need to spend $1.33 trillion (0.75 x $400 billion / 0.25).

• The central bank agrees to adjust the money supply to hold the interest rate constant to avoid crowding out. This is necessary because if the central bank did not adjust the money supply, the increase in government spending would increase aggregate demand, which would increase interest rates and crowd out private investment.

• If fiscal policymakers spend an extra $100 billion more than what was computed in b), the result will be an increase in aggregate demand, which will shift the AD curve to the right. The new equilibrium point will be at C, with higher output and a higher price level.

• If no additional fiscal or monetary action is taken, the economy will eventually return to the long-run equilibrium. In the long run, prices and wages will adjust to the new level of output, and the short-run aggregate supply curve will shift to the left until it intersects with the long-run aggregate supply curve at point D. At this point, output will return to the natural level, but the price level will be higher than it was at the original equilibrium point A.