Question

5. Essay Given the following data, draw and label a graph of the economy. Cuurent RGDP = $21 trillion, LRAS = $25 trillion. MPC = .6, RRR = .05, Discount Rate = .05% Now show and discuss what would happen to the economy as a result of the classical theory. Now show and discuss what would happen to the economy as a result of fiscal policy. Now show and discuss what would happen to the economy as a result of monetary policy.

Answer 1

Answer 5:

a. The current level of actual Real GDP in the economy is below the long run potential level of GDP in the economy which means that economy is currently operating in recessionary gap. According to the Classical Theory, self adjustment of the economy towards the potential level of GDP will take place in the economy when real wages will fall because of increased unemployment in the economy and this will reduce cost of production in the economy shifting SRAS curve rightwards and moving the actual level of Real GDP equal to the long run potential level of GDP in the economy.

b. Since the economy is in the recessionary gap, expansionary fiscal policy in the form of increasing government expenditure and reducing tax rate in the economy needs to be followed to move the actual level of real GDP equal to the full employment level of Real GDP in the economy and eliminate recessionary gap in the economy.

c. As a result of expansionary monetary policy which involves increasing the level of money supply in the economy by reducing the level of discount rate in the economy, the aggregate demand in the economy will increase and this increase in the level of aggregate demand will move the actual level of GDP in the economy closer to the potential level of GDP in the economy.