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Inflationary vs. Recessionary Gaps

3. An economy is in long-run macroeconomic equilibrium when each of the following aggregate demand shocks occurs. What kind of gap?inflationary or recessionary?will the economy face after the shock, and what type of fiscal policies would help move the economy back to potential output?
a. A stock market boom increases the value of stocks held by households.
b. Firms come to believe that a recession in the near future is likely.
c. Anticipating the possibility of war, the government increases its purchases of military equipment.
d. The quantity of money in the economy declines and interest rates increase.

5. In each of the following cases, either a recessionary or inflationary gap exists. Assume that the aggregate supply curve is horizontal so that the change in real GDP arising from a shift
of the aggregate demand curve equals the size of the shift of the curve. Calculate both the change in government purchases of goods and services and the change in government transfers necessary to close the gap.
a. Real GDP equals $100 billion, potential output equals $160 billion, and the marginal propensity to consume is 0.75.
b. Real GDP equals $250 billion, potential output equals $200 billion, and the marginal propensity to consume is 0.5.
c. Real GDP equals $180 billion, potential output equals $100 billion, and the marginal propensity to consume is 0.8.

6. Most macroeconomists believe it is a good thing that taxes act as automatic stabilizers and lower the size of the multiplier. However, a smaller multiplier means that the change in government purchases of goods and services, government transfers, or taxes necessary to close an inflationary or recessionary gap is larger. How can you explain this apparent inconsistency?

13. In which of the following cases does the size of the government's debt and the size of the budget deficit indicate potential problems for the economy?
a. The government's debt is relatively low, but the government is running a large budget deficit as it builds a high speed rail system to connect the major cities of the nation.
b. The government's debt is relatively high due to a recently ended deficit-financed war, but the government is now running only a small budget deficit.
c. The government's debt is relatively low, but the government is running a budget deficit to finance the interest payments on the debt.

Solution Preview

3 a.As people see the values of their portfolios increasing, they will increase their spending (the wealth effect). This shifts the AD curve to the right, and will cause and inflationary gap. To close the gap, the government could use contrationary fiscal policies.

b. If firms become concerned about a recession in the near future, they will decrease investment spending and aggregate demand will shift to the left. The economy will face a recessionary gap. Policy makers could use expansionary fiscal policies to move the economy back to potential output.

c. If the government increases its expenditures, the aggregate demand curve will shift to the right. The economy will face an inflationary gap. Contractionary fiscal policies can be used to move the economy back to potential output.

d. Higher interest rates rise will cause investment spending to decrease and the aggregate demand curve to shift to the left. A ...

Solution Summary

How shocks affect the economy and remedies to restore potential output.

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