Question

(request : elaborate a bit longer )

Question 2 Assume that an economy is initially operating at the natural rate of output (full employment output). Use the AD-AS model to illustrate graphically the effects on price and output of an INCREASE in government spending. Explain your assumptions with respect to the range of aggregate supply of your analysis.

Question 3 Explain in detail the process of Monetary Policy transmission of a decrease in the cash interest rate. Use relevant graphs to describe how a Central Bank’s action on the interest cash rate ripple through the economy and lead to the target policy goal. (Three connected diagrams should be used: (1) money supply and demand (2) investment demand schedule (3) AS/AD diagram. Interest rates is the variable that connects the first and second diagram).

Answer 1

Question 2

Sol

Initially economy is at full empliyment level producing Y^* output, price level is P₀ . Increase in government spending will increase aggregate demand . In response to increased demand aggregate supply will increase multiplier times increase in government expenditure . At constant price output will increase to Y^'. In short run economy will operate above fullemployment level, unemployment will fall below natural level at constant money wage. However in the longrun money wage will increase and price level will also increase so that economy comes back to natural rate of unemployment . Finally price level becomes P₁ and full employment output is restored. It is assumed that MPC is constant and interest rate remains unchanged. If interest rate is not constant increase in short run output will be lower due to decrease in value of multiplier.