Question

Suppose that the economy is at full employment, the price level is 100 , and the multiplier is 2 . Investment increases by \(\$ 100\) billion. a. What is the immediate change in the quantity of real GDP demanded? b. In the short run, does real GDP increase by more than, less than, or the same amount as the immediate change in the quantity of real GDP demanded?

Short answer

a. $200 billion. b. In the short run, real GDP may increase less than the immediate change due to full employment.

Step-by-step solution

Determine the Immediate Change in Real GDP Demanded

To find the immediate change in the quantity of real GDP demanded, use the formula: \text{Change in GDP } = \text {Multiplier} \times \text{Change in Investment}Substitute the given values: \text {Multiplier} = 2\text { and Change in Investment } = \(100\text { billion}Therefore, \text {Change in GDP} = 2 \times 100 = \)200 \text { billion}

Evaluate the Short-Run Change in Real GDP

In the short run, the actual increase in real GDP can be different from the immediate change in the quantity of real GDP demanded due to price level adjustments and other economic factors. Since the multiplier effect suggests that the equilibrium GDP should increase by the multiplied amount of the change in investment, the real GDP is likely to increase by the same amount as the immediate change. However, because the economy was initially at full employment, the actual increase in GDP might be limited by the economy’s capacity to expand output.

Compare the Immediate Change and Short-Run Change

In summary, while the immediate change in the quantity of real GDP demanded is \(200 billion, in the short-run, the actual increase in real GDP may not fully reach \)200 billion due to limitations like full employment. However, in theory, they could be same if the economy can adjust fully. Therefore, comparing both, the real GDP increase in short-run could be less than the immediate change.

Key concepts

Real GDP

Real Gross Domestic Product (Real GDP) represents the total value of all goods and services produced within a country's borders, adjusted for inflation. It provides an accurate measure of a country's economic performance over different time periods.

In macroeconomics, Real GDP removes the effect of price level changes, allowing for a more precise analysis of economic growth. When economists discuss changes in Real GDP, they're referring to the actual change in output, not influenced by inflation or deflation.

Real GDP is used to compare the economic performance of different years and to assess the health of an economy by providing a snapshot of productivity. For instance, in the exercise, the change in Real GDP demanded is calculated to understand the impact of an increase in investment on the economy's output.

Full Employment

Full employment refers to a situation where all available labor resources are being used in the most efficient way possible. In other words, every person who wants and is able to work has a job.

At full employment, the economy operates at its maximum sustainable output level, known as the natural level of Real GDP. This doesn't mean zero unemployment; rather, it includes frictional and structural unemployment, which are natural in a dynamic economy.

In the given exercise, the initial condition of full employment means the economy is already operating at its full capacity. Therefore, any increase in demand from the multiplier effect of investment might not lead to a proportionate increase in actual output, because the economy cannot produce much more than it already is.

Short-Run Economic Analysis

Short-run economic analysis examines the behavior of the economy over a shorter period, taking into account factors like price level adjustments and wage rigidity that don't hold in the long run.

In the short run, an economy can experience fluctuations due to temporary changes in demand or supply. Factors such as sticky prices and wages can slow the adjustment process to a new equilibrium level.

In the exercise, while the immediate change in the quantity of Real GDP demanded due to increased investment is calculated using the multiplier effect, the actual short-run change in Real GDP may be limited. This is because the economy at full employment cannot increase output without causing inflationary pressures due to the short-run limitations on resources and production.

Investment Impact on GDP

Investment plays a critical role in driving economic growth and influencing GDP. When businesses invest in capital goods, infrastructure, or technology, it can lead to increased production capacity and higher output.

The multiplier effect explains how an initial increase in investment can lead to a larger overall increase in GDP. For instance, in the exercise, an additional \(\$100\) billion in investment results in a \(\$200\) billion change in Real GDP demanded because of a multiplier of 2.

However, the actual impact on GDP depends on the current economic state. In a full employment scenario, the capacity to increase output is constrained, meaning that the increase in Real GDP might be less than predicted by the multiplier, due to limited resources.

Understanding the relationship between investment and GDP helps policymakers design effective fiscal policies to stimulate growth, especially in times of economic slack where resources are underused.