AP Macro · Unit 5 · Long-Run Consequences of Stabilization Policies

Assume that Wexholm's economy is currently in a recessionary gap following a negative demand shock. The unemployment rate is $8\%$, the natural rate of unemployment ($NRU$) is $5\%$, and both the actual and expected rates of inflation are $1\%$. Real GDP ($Y_1$) is below the full-employment level of output ($Y_F$).

(a) Draw a correctly labeled graph of the short-run and long-run Phillips curves for Wexholm's economy. On your graph:

• (i) show the downward-sloping short-run Phillips curve ($SRPC$) and the vertical long-run Phillips curve ($LRPC$) at the natural rate of unemployment of $5\%$

• (ii) label the current short-run equilibrium as point $A$, at an unemployment rate of $8\%$ and an inflation rate of $1\%$
  (b) To close the recessionary gap shown in part (a), Wexholm's government increases spending on public infrastructure by $5 billion, financed entirely by government borrowing. State what will happen to the real interest rate in the loanable funds market, and explain the mechanism that causes this change.
  (c) On your graph in part (a), show the short-run effect of the increase in government spending described in part (b). Label the new short-run equilibrium point $B$, reflecting an unemployment rate of $3\%$ and an inflation rate of $4\%$.
  (d) Draw a correctly labeled graph of the AD-AS model for Wexholm's economy that illustrates the effect of the increase in government spending described in part (b). On your graph:

• (i) show the initial aggregate demand curve $AD_1$, the short-run aggregate supply curve $SRAS$, and the vertical long-run aggregate supply curve $LRAS$, with the initial equilibrium at output $Y_1$, below full-employment output $Y_F$, at price level $PL_1$

• (ii) show a new aggregate demand curve, $AD_2$, shifted to the right of $AD_1$ as a result of the increase in government spending

• (iii) label the new equilibrium at output $Y_2$, beyond $Y_F$, at a higher price level $PL_2$
  (e)(i) Given the increase in the real interest rate identified in part (b), will private investment increase, decrease, or remain the same? Explain.
  (e)(ii) Given the inflationary gap shown in part (d), will workers' expected rate of inflation increase, decrease, or remain the same in the long run? Explain.