Question

Assuming a demand driven economy:

a. Write down a complete, parametric system of equation that defines the macroeconomic equilibrium of this economy.

b. Derive the AE as a function of actual national income and interpret it and every parameter of it.

c. Solve for equilibrium national income.

d. Using your answer in part (c), interpret the simple multiplier.

e. Show in a graph the effect of the simple multiplier after an exogenous change in the autonomous part of the AE. Clearly and precisely explain the mechanism that generates the multiplier effect.

f. What are the assumptions in the background of this model? Clearly discuss the importance and the effects of these assumptions on the working of the mode. What happens if the assumption regarding the price level is relaxed?

g. Graphically explain the process of deriving aggregate demand curve.

h. Graphically show the effect of the simple multiplier for an exogenous change in autonomous aggregate expenditure using the AD curve and its connection with the AE curve. Does the simple multiplier give an accurate indication of the change in equilibrium national income if the assumption on the price level is relaxed? Explain why.

j. Introducing the supply side of the economy to this model, explain, and graphically illustrate, the effect of a negative aggregate supply shock on equilibrium. Explain every effect of such a change and the mechanism behind it.

k. Consider a level of potential output that is above a typical equilibrium of this economy. If you were to advise the government on proper fiscal policy, what sort of policy would you advise?

l. Assume that the policy you recommend is implemented by the government. Clearly and precisely explain every effect of this policy and the mechanisms that will result in a change in equilibrium real GDP in this economy. How would this policy affect the price level? Graphically show all the changes in the model.

m. What happens to the ultimate impact of the policy you advise in previous part if at the same time that the policy is implemented the cost of labour increases for all firms due to exogenous reasons? Can you determine whether the effects on equilibrium real GDP or equilibrium price level are certain. If not certain, what do they depend on? Clearly explain.

Answer 1