Question

Other things equal, what effect will each of the following changes independently have on the equilibrium level of real GDP in a private closed economy?

1. A decline in the real interest rate.

2. An overall decrease in the expected rate of return on investment.

3. A sizable, sustained increase in stock prices.

Short answer

1. Equilibrium real GDP will increase.

2. Equilibrium real GDP will reduce.

3. Equilibrium real GDP will increase.

Step-by-step solution

Step 1. Explanation for part (a)

A decline in the real interest rate means lower investment costs. As a result, the investment will increase. Other things being constant, a higher investment expenditure will boost the overall spending of the economy. It will create an imbalance between output produced and purchased.

The real GDP will rise to reach the equilibrium level of spending.

Step 2. Explanation for part (b)

Other things being constant, if the expected rate of return declines, the aggregate investment demand will fall, ultimately reducing the investment expenditure of the economy.

Lower total spending will again disturb the equilibrium real GDP. Therefore, firms will have to cut down the production, and equilibrium real GDP will decline.

Step 3. Explanation for part (c)

A sizeable, sustained increase in stock prices increases the wealth of individuals, which will increase their disposable income, and thus the consumption expenditure will increase.

Enormous consumption expenditure will increase the total spending of the economy, and output will be underproduced. To maintain the equilibrium, the firms have to expand their production. Therefore, the equilibrium real GDP will increase.