AP Macro · Unit 3 · National Income and Price Determination

Assume that the economy of Wexholm is currently in long-run macroeconomic equilibrium, producing a real GDP of $800 billion with an unemployment rate of 5%, equal to the natural rate of unemployment, and a stable price level. To modernize the country's infrastructure, the legislature increases government spending by $40 billion, financed entirely by borrowing, and the marginal propensity to consume (MPC) in Wexholm is 0.75. At the same time, concerned that this spending increase will cause inflation, the Central Bank of Wexholm sells government bonds on the open market, raising the nominal interest rate and reducing planned investment spending. Economists estimate that the aggregate-demand-decreasing effect of the central bank's action is smaller in magnitude than the aggregate-demand-increasing effect of the fiscal expansion.

(a) Draw a correctly labeled graph of aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) for Wexholm's economy, and show each of the following.

• (i) The current equilibrium output and price level, labeled $Y_1$ and $PL_1$, respectively

• (ii) The full-employment output, labeled $Y_F$, coinciding with $Y_1$
  (b) On your graph from part (a), show the short-run effect of the $40 billion increase in government spending on Wexholm's economy, labeling the new aggregate demand curve $AD_2$ and the new equilibrium output and price level $Y_2$ and $PL_2$.
  (c) In response to concerns about rising inflation, the Central Bank of Wexholm, whose banking system has limited reserves, sells government bonds on the open market. Draw a correctly labeled graph of the money market and show each of the following.

• (i) The initial equilibrium nominal interest rate and quantity of money, labeled $r_1$ and $Q_1$

• (ii) The effect of the central bank's bond sales on the money supply curve and the resulting new equilibrium interest rate, labeled $r_2$
  (d) Calculate the value of Wexholm's spending multiplier, given that the marginal propensity to consume is 0.75. Show your work.
  (e)(i) Given that the aggregate-demand-increasing effect of the fiscal expansion in part (b) is larger in magnitude than the aggregate-demand-decreasing effect of the monetary contraction in part (c), will Wexholm's real GDP increase, decrease, or remain the same in the short run relative to $Y_F$? Explain.
  (e)(ii) Given the same information from parts (b) and (c), will Wexholm's price level increase, decrease, or remain the same in the short run relative to $PL_1$? Explain.
  (f) Given that Wexholm's economy remains in an inflationary gap in the short run, state what will happen to nominal wages in the long run and explain how this change will affect the SRAS curve as the economy returns to long-run equilibrium.