Question

7. Which of the following statements best explains the mechanism by which the economy will eventually return to long-run equilibrium after the decrease in transfer payments? Assume no other changes in government spending and taxation programs.

		A.  The reduction in the inflation rate due to the decrease in aggregate demand causes businesses to lower their expectations about the price level. This leads firms to produce more, shifting the short-run aggregate supply curve to the right, returning the economy to its natural rate of output.
		B.  The reduction in the inflation rate due to the decrease in aggregate supply causes businesses to increase investment, shifting the aggregate demand curve to the right, returning the economy to its natural rate of output.
		C.  The reduction in the inflation rate due to the increase in aggregate demand causes businesses to raise their expectations about future inflation. This leads firms to produce more, shifting the short-run aggregate supply curve to the right, returning the economy to its natural rate of output.

Question

Additionally, as the inflation rate rises, the impact on the domestic interest rate will cause the real value of the dollar to ______ (rise/fall) in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore _______ (fall/ remain the same/ rise), and the number of foreign products purchased by domestic consumers and firms (imports) will ______ (fall/ remain the same/ rise). Net exports will therefore _________ (fall/ remain the same/ rise), causing the quantity of domestic output demanded to ___________(fall/ remain the same/ rise). The phenomenon is known as the ___________ (exchange rate/ interest rate/ wealth) effect.  

Answer 1

Answers and explanations are as below:

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7. Which of the following statements best explains the mechanism by which the economy will eventually return to long-run equilibrium after the decrease in transfer payments? Assume no other changes in government spending and taxation programs.

Correct choice:

A) The reduction in the inflation rate due to the decrease in aggregate demand causes businesses to lower their expectations about the price level. This leads firms to produce more, shifting the short-run aggregate supply curve to the right, returning the economy to its natural rate of output.

Explanation: Due to the decrease in transfer payments, aggregate demand decreases. This causes a reduction in the price level. This makes factors of production cheaper. Firms respond by increasing production, and this causes the AS to shift to the right. The economy once again moves towards the long run equilibrium.

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Why other option are incorrect:

Even if AS decreases, the inflation should actually rise. Thus, option B is wrong.

If transfer payments are decreased, AD would fall. Thus, option C is wrong.

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Question

Additionally, as the inflation rate rises, the impact on the domestic interest rate will cause the real value of the dollar to fall in foreign exchange markets.

The number of domestic products purchased by foreigners (exports) will therefore rise, and the number of foreign products purchased by domestic consumers and firms (imports) will fall.

Net exports will therefore rise, causing the quantity of domestic output demanded to fall.

The phenomenon is known as the exchange rate effect.

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Explanation:

As domestic inflation rises, the real exchange rate depreciates. This causes exports to become cheaper, while imports become costlier. Net exports rise. The domestic inflation causes domestic demand to fall.