Question

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? How would your recommended fiscal policy shift the aggregate demand curve? 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.

Short answer

Answer: A stock market boom that increases the value of stocks held by households creates an inflationary gap. Contractionary fiscal policies, such as increasing taxes or reducing government spending, can be used to correct the gap and bring the economy back to potential output.

Step-by-step solution

a. A stock market boom increases the value of stocks held by households.

An increase in the value of stocks will make households feel wealthier, leading to an increase in consumer spending. This increase in spending will cause the aggregate demand curve to shift to the right, resulting in inflationary pressure and an inflationary gap. To correct this gap and bring the economy back to potential output, contractionary fiscal policies can be used. For example, the government could increase taxes or reduce its spending, which would decrease the disposable income in the economy and reduce consumer spending. This shift would cause the aggregate demand curve to shift back to the left, bringing the economy back to equilibrium.

b. Firms come to believe that a recession in the near future is likely.

If firms expect a recession in the near future, they may reduce their investment spending, which in turn will cause the aggregate demand curve to shift to the left. This shift will result in a recessionary gap. To correct this gap and bring the economy back to potential output, expansionary fiscal policies can be used. The government could either increase its spending or decrease taxes to stimulate consumer and business spending. This policy would shift the aggregate demand curve to the right, bringing the economy back to equilibrium.

c. Anticipating the possibility of war, the government increases its purchases of military equipment.

When the government increases its purchases of military equipment, this will directly increase government spending, causing the aggregate demand curve to shift to the right. This shift will create inflationary pressure and an inflationary gap. To correct this gap and bring the economy back to potential output, the government can implement contractionary fiscal policies such as increasing taxes or decreasing non-military spending. These policies would shift the aggregate demand curve back to the left, bringing the economy back to equilibrium.

d. The quantity of money in the economy declines and interest rates increase.

A decline in the quantity of money and an increase in interest rates would affect both consumer and business spending. The higher interest rates discourage borrowing, which in turn reduces investment and consumption. The aggregate demand curve would shift to the left, resulting in a recessionary gap. To correct this gap and bring the economy back to potential output, the government can implement expansionary fiscal policies, such as increasing government spending or decreasing taxes. These policies would stimulate consumer and business spending, shifting the aggregate demand curve to the right, and bringing the economy back to equilibrium.