Question

You are an economic advisor to the president. You observe a decrease in gross investment. Assume the economy was operating at the full-employment level of real GDP prior to the decrease in gross investment.
Describe the state of the economy and advise the president on the appropriate policy action by completing the following sentences

a. The increase in exports will lead to ___________ in net exports and in turn ___________ in aggregate demand As a result, real GDP will ____________
b. The problem that this event will cause is ____________
c. Appropriate ___________ policy actions would include ___________taxes and or_______ goverment purchase.
d. These actions will smooth out the business cycle by __________ actual real GDP back toward full-employment GDP.

Answer 1

Answer:

a. Increase in Net Exports, Increase in AD, real GDP will stay same

b. Excess Demand

c. Appropriate Contractionary Fiscal Policy : decrease tax & or increase government expenditure

d. Actions smooth business cycle by brining actual real GDP towards full employment

Explanation:

Aggregate Demand is the total value of goods & services all the sectors of an economy are planning to buy during a given period of time

Aggregate Demand [AD] = Consumption [C] + Investment [I] + Government Expenditure [G] + Net Exports [NX = Exports (X) - Imports (M)]

Aggregate Demand > Aggregate Supply at full employment level is Excess Demand. Aggregate Demand < Aggregate Supply at full employment level is Deficit Demand

Decrease in Investment leads to fall in Aggregate Demand. It creates Deficit Demand & decreases real GDP. It can be corrected through demand expansionary fiscal policy of decreasing taxes & increasing govt. expenditure.

Increase in exports leads to increase in net exports & in turn increase in aggregate demand. This causes Excess demand problem & real GDP will remain same (economy already at full equilibrium, GDP cant be increased more). Appropriate Fiscal Policy [Contractionary Fiscal Policy] includes decreasing taxes & or increasing govt. purchase.

These actions will smooth out business cycle by bringing actual real GDP back to full employment level.