Economics 102

L. Stone

Spring 2003

Quiz 10

 

1.  Suppose that investors become more pessimistic; that is, at every level of the interest rate, they wish to invest less.  Show on the graphs below, and explain (using either words or symbols) what will happen in the short run and the long run. (15 points)

 

In the short run:  :  I falls, C + I + G falls, AD falls, Y falls, P falls

In the long run:   Y<YF so wages and prices fall.  Money demand falls, and thus interest rates fall.  Therefore the quantity of investment rises, C+I+G rises.  Since prices fall, AS shifts rightward.  Prices fall further, and output returns to full employment output.

 

2.  Refer to the situation above.

 

a.  How could the short-run situation above be corrected using fiscal policy?  Using monetary policy?  (Be sure to make clear which is which in your answer.)  (4 points)

 

Fiscal:  Lower taxes or increase government spending

Monetary:  Lower the discount rate or lower reserve requirements or buy bonds.

 

b.  Why would it be more difficult to correct a supply shock?  Carefully explain.  (You may wish to use a graph to clarify your answer.)  (6 points)

 

Fiscal and monetary policies act on aggregate demand.  In the case of a supply shock, price and output move in opposite directions, so changing demand will correct part of the problem but not all of it (in the above case, reducing demand will lower output but cause deflation).