Question

Describe and explain the short-run and long-run effects of an exogenous increase in investment on a closed economy in the short run.

1. What is the effect of an exogenous increase in investment in the Aggregate Demand/Aggregate Supply (AD/AS) diagram?

2. Consumption

3. Real GDP

4. Price level

5. Unemployment

6. Interest rate

7. Investment

Answer 1

Answer - The adjustments are as follows -

The solution is explained by the diagrams given at the last of the answer -

As a result of the
increase in investment, which
is a component of AD, the AD
will shift right. This can be seen
in the diagram bclow. The rise
in investment will lead to rise in
income and hence
consumption will also risc. The
rightward shift in AD will lead
to rise in the price level and real
GDP. Since real GDP is rising
the unemployment rate will fall.
There will be creation of
inflationary gap in the
cconomy. Due to greater
demand for investment in
economy, more money will be
demanded leading to rise in
interest rates.
Hence in long run, the
investment and consumption
will fall due to high interest
rates and AD will shift back to
the potential level closing the
inflationary gap.

Long Run adjustment will be -