Answered: AS-AD diagram

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

Suppose that the federal government decides to reduce the budget deficit and cuts government purchases by $200 billion and raise personal income taxes by $200 billion. Suppose the MPC = .5. How much and in which direction would the AD curve shift because of the government spending cut? Show your work. How much and in which direction would the AD curve shift because of the tax increase? Show your work. (Note: we know these numbers in parts A & B are not accurate quantitative assessments of the policy actions - but the exercise allows us to think about the mechanisms through which these policy actions will affect the economy.) Using the above numbers, draw the AS-AD diagram and illustrate the short-run impact of the combined policy action assuming the economy begins at potential output. Label the original equilibrium with point "A" and the new short-run equilibrium with point "B". Be sure to label the magnitude of the curve shift. Describe the impact of the policy action on employment/unemployment, spending, and prices/inflation. Be sure to include the impact of the spending multiplier. In moving from points "A" to point "B" on the AS-AD diagram, why do firms change their production? Characterize the labor market at point "B". Eventually wages and prices fully adjust. Describe this process. Illustrate the impact of the wage and price adjustment using the AS-AD diagram. Label the new equilibrium as point "C".

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