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    a. Assume initially that the economy is in a state of long-run equilibrium. The real GDP equals potential GDP and only natural unemployment exists. Now suppose that consumer confidence plummets and the aggregate demand decreases. What will happen to the general price level (P) and the real GDP (Y) in the short run? Why? What will happen to P and Y in the long run? Why? Describe the process of self-correcting mechanism from the beginning to the end.
    b. After the aggregate demand decreases in part "a" above, what kind of a demand-management policy would a typical liberal economist propose, an active policy or do nothing? How about a conservative economist? What justifications would they provide for their respective proposed policies?
    c. In general, how does an expansionary monetary policy work? (Describe the steps through which an increase in money supply affects the real GDP).
    d. In general, how does fiscal policy work? (Describe the steps through which an increase in G or TR, or a decrease in TX, affects the real GDP).
    e. What are the advantages and disadvantages of using an expansionary monetary policy in a recession compared to using fiscal policy? (Please note: I am not asking you how monetary policy works. You have already answered it in part c above. The question is specifically about the advantages of monetary policy compared fiscal policy in a recession).
    f. What are the advantages and disadvantages of using an expansionary fiscal policy in a recession (That is, compared to using monetary policy)?

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    Solution Preview

    a. If consumer confidence plummets and aggregate demand decreases, the general price level decreases and the real GDP also decreases in the short run. The short run aggregate supply curve is upward sloping and with a decrease in aggregate demand, the new equilibrium point is lower than the earlier point. This means the price level or inflation decrease and real output also decreases. In the short run suppliers find it difficult make supplies. In the long run P will decrease and the Y will return to the earlier output. The long term aggregate supply curve is vertical. It does not change with short term changes in demand. The self corrective process is one that eliminates temporary imbalances in resource markets, especially because of unemployment and over employment of labor. The self correction process closes both the recessionary gaps and inflationary gaps (1). When short run equilibrium real production is less than full employment real production, the resource markets have a surplus and there is a recessionary gap. Self-correction takes place in the short run by increasing aggregate supply, and in the long run by lowering wages. In case of an inflationary gap, where the resource markets have shortages and labor is over employed, self correction leads to a decrease in short run aggregate supply and in the long run there is higher wages.

    b. If demand decreased as explained in part (a), a liberalist economist would advocate an economic policy by the government to stimulate demand in times of high unemployment. For example, the government may spend more on public works, or construction of ...

    Solution Summary

    The answer to this problem explains important macroeconomics issues. The references related to the answer are also included.