Question

4. The United States invaded Afghanistan on October 7th 2001 and Iraq on March 30th 2003. Taking these wars as a single event, show what effect the increase in governments spending for the war should have on the AS-AD model. What happens to prices, output and unemployment? a. This question obviously requires a graph and a written explanation. You need several clearly labeled graphs to answer this question. i. ii. You also need to explain what is happening in the economy that is no explicitly graphed. b. c. d. e. Explain what curve shifts first and why. Show this with a graph. What will this do to the unemployment rate and wages? How will this affect the aggregate economy? Explain Draw a graph to accompany the question above. b. The Federal government also cut taxes at roughly the same time. What should the combination of tax cuts and the war spending do to the market for loanable funds? This question obviously requires a graph and a written explanation.

Answer 1

(a) The war increases defense spending, raising government purchases. Price level and output both rise and unemployment falls.

(b) Aggregate demand (AD) curve will shift first, in the rightward direction. In following graph, AD0 and SRAS0 are initial aggregate demand & short run aggregate supply curves intersecting at point A with initial price level P0 and output Y0. As government spending rises, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher output Y1.

SRASo ADI ADO Yo Y

(c) Since income and output will rise, unemployment will fall because labor demand will be higher. As labor demand rises, wage rate will increase.

(d) This will lead to higher real GDP, output and income in the economy along with higher inflation.

(e) The graph is drawn above.

(b) Higher spending and lower tax will increase budget deficit, to finance which government will resort to borrowing. This will increase the demand for loanable funds, shifting the demand curve rightward, increasing both interest rate and the quantity of loanable funds. In following graph, D0 & S0 are initial demand & supply for loanable funds intersecting at point A with interest rate r0 and quantity of loanable funds Q0. As demand shifts right to D1, it intersects S0 at point B with higher interest rate r1 and higher quantity of loanable funds Q1.

to Do Di 80