Macro Question! AD, very shorts runs, GDP?
1. Economy A has a baseline consumption of $30. There is no government and no foreign trade. The
economy is known to spend $0.60 more as income increases by $1. Investment spending is currently at
$30.
Consider economy A above, in long-run equilibrium with GDP = $150.
a) Consumer confidence falls, reducing consumption initially by $10. What happens to GDP in
the very short run? What is the resulting GDP in the very short run? Draw the income-expenditure
diagram to illustrate this change.
b) What happens to aggregate demand (AD) as a result of a) (increase or decrease)? Illustrate
with a diagram.
c) There is no change in Potential GDP. Is economy A in its long-run equilibrium after the
change in a)? If not, is there an inflationary or recessionary gap?
d) Use the AD/AS diagram to illustrate the economy's adjustment in the short run. Indicate
what happens to GDP and the price level.
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e) Use the AD/AS diagram to illustrate the economy's adjustment in the long run. Indicate what
happens to GDP and the price level. Describe the mechanism of the adjustment.
f) The government can influence aggregate demand (AD). Given your answer in f), should the
government intervene to increase or decrease aggregate demand (AD)? What will this policy achieve?

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