Question

3b. Evaluate/Interpret the followings: (10 marks) (0) The Federal government (central bank) can shift the aggregate demand curve, what will happen to te demand and demand curve shift, if interest rate decrease and if interest rate increase.( support with diagram) (2 marks) (i) Compare "The multiplier effect" and the "crowding-out effeet" (2 marks) (ii) Compare "The misery index" and "Phillips curve" (2 marks)

Answer 1

(i) When the Fed raises the interest rate by reducing the money supply, there is a reduction in investment spending. With lower investment demand, aggregate demand would decrease and so aggregate demand curve shifts to the left.

When the Fed reduces the interest rate by increasing the money supply, there is an increase in investment spending. With higher investment demand, aggregate demand would increase and so aggregate demand curve shifts to the right

ii) Since a fraction of a dollar earned is saved and only a part of it is spent, an increase in autonomous spending raises the real GDP by multiple times. This multifold increase in income occurs through the multiplier effect where simple spending multiplier is 1/1-mpc where mpc is fraction of increased disposable income spent or marginal propensity to consume. Crowding out effect occurs as a result of increased government spending where a deficit in the budget is financed through loanable funds market by borrowing. This raises interest rate on these funds, which then discourage private investment.

iii) Phillips curve associates short run unemployment rate with the rate of inflation in an inverse relation. The two move in opposite in direction in the short run and the relationship is broken in long run where rate of unemployment is fixed at its natural rate and only rate of inflation varies. Misery index is also called a discomfort index, an unofficial statistic computed as a sum of unemployment rate and inflation rate. This index attains a highest value when there is a prolonged recession or the recession hits the economy immediately