Question

1. Between 2007 and 2008 investment declined from an annual rate of $2160 billion to $1930 billion as the U.S. economy found itself in yet another recession. As a result of the recession, the unemployment rate grew to 9.3 % by 2009.  Assume MPC= .75

a) How did the decline in investment between 2007 and 2008 affect Aggregate Demand (AD)?  Show or explain your work.    (5 pts)

b) Assume the AD shortfall in 2009 was $1240 billion. As an economic adviser to the President, what change in income transfers (transfer payments) would you have recommended? Be specific and show or explain your work. (8 pts)

c) Assume that by 2015 the economy was growing too rapidly and, therefore, inflationary pressures emerged. If the AD Excess was $425 billion, what change in government expenditures on goods and services  would you recommend ? Be specific and show or explain your work. (5 pts)

d) Assume that by 2015 the economy was growing too rapidly and, therefore, inflationary pressures emerged and the government increased income taxes by $90 billion. What was the effect of the tax increase on AD ? Be specific and show or explain your work. (8 pts)

Answer 1

MPC is marginal propensity to consume. Multiplier = 1/1-MPC

this means that multiplier will be 4. Each $ put will become $4 to increase GDP.

Investment in between 2007 and 2008 declined by 2160-1930 = $230 billion and this means that 230*4= $920 billion GDP will be less and causes recessionary gap.

a. As shown above, real GDP declines by $920 billion and there is recessionary gap created as real GDP is lessthan potential.

b. 1240/4=$310 billion can be put and this shortfall will be covered as multiplier is 4 in this case. It will put money in people hand and they will

c. During inflationary gap, investments should be lessby 425/4= $106.25 billion and government can follow contractionary fiscal policy to cut down expenditure or raise tax.

d. Raising tax of $90 billion will reduce GDP by 90*4= $360 billion. Aggregate demand will shift to left.