ELS Chapter 12: Graphing Exercise 2 Answers
Federal Reserve Policy and the Macroeconomy
1. What is the initial short-run equilibrium level of output in the economy illustrated above? How do you know? What are the initial levels of consumer expenditures (C), investment (I), government purchases (G), and net exports (NX) at this equilibrium?
  answer: The initial short-run equilibrium level of output is $10,000 billion. At this level of output, aggregate demand is exactly equal to production (output), as illustrated by the intersection of aggregate demand and the 45-degreee line. At any other level of output (read on the horizontal axis), the level of aggregate demand is different from the level of output, which will generate a shortage or surplus of goods. At the initial short-run equilibrium, the level of consumer expenditures is $6500 billion, investment spending is $1000 billion, and (government purchases + net exports) are $2500 billion, while the real interest rate is 10% (.10).
2. If autonomous consumer spending falls by $500 billion due to declining consumer confidence about the economy, what will be the effect on the short-run equilibrium level of output in the economy? What type of "gap" is created by the fall in consumer expenditures?
  answer: A reduction in autonomous consumer expenditures causes a reduction in planned aggregate expenditures, shifting the PAE line down. At the original level of output ($10,000 billion), PAE is now less than output (Y), so firms will have a surplus of goods and will respond by reducing production until output and aggregate expenditures are again equal. This occurs where the AD line crosses the 45-degree line, at the output level $9000 billion. Output has fallen by $1000 due to the $500 billion reduction in consumer spending. The reduction in aggregate expenditures has created a recessionary gap, since the new equilibrium level of output is less than potential output.
3. Given the scenario in question #2, what can the Federal Reserve do to bring the economy back to equilibrium at potential output (full employment)? What happens to consumer spending, investment spending, and output as a result of the Fed's actions?
  answer: To close the recessionary gap the Federal Reserve would need to reduce nominal interest rates. As the nominal (and real) interest rate falls, consumer and investment spending both increase, shifting the PAE line up. As a result, the equilibrium level of output in the economy moves back toward potential.

4.

 If consumers in Japan purchase $200 billion fewer American goods due to a slowdown in the Japanese economy, what effect will this have on the U.S. economy? What would the Federal Reserve do in this situation if they want to keep the U.S. economy operating at potential?
  answer: A reduction in Japanese purchases of U.S. goods reduces net exports by $200 billion, shifting the PAE line down, reducing the equilibrium level of output, and creating a recessionary gap. The Federal Reserve would respond by reducing U.S. interest rates, increasing both investment and consumption spending and shifting the PAE line upward until it intersects the 45-degree line at potential output once again.

5.

 Restore the original values in the model by clicking on the Reset button. If planned investment spending increases by $500 billion, what happens to equilibrium output in the economy? Assuming that the economy was originally at the potential output level, what type of "gap" is created by the increase in consumer expenditures? How should the Federal Reserve respond? Explain.
  answer: Increased planned investment spending causes the PAE line to shift up. At the original level of output ($10,000 billion), planned aggregate expenditure is now greater than production, shortages of goods will appear, and firms will respond by increasing production. At the new equilibrium level of output (where PAE=Y) there is now an expansionary gap. An expansionary gap can lead to future inflation, because the current level of production is higher than the long-run productive capacity of the economy. Eventually such a situation is likely to lead to higher costs of production and higher prices.

To eliminate the expansionary output gap, the Federal Reserve must increase the real interest rate (by selling government bonds). As the real interest rate rises, consumer and investment spending both fall, which reduces aggregate expenditures until aggregate spending is equal to output at potential GDP.

6.

 Based on your analysis of monetary policy in questions #3, #4, and #5, what do you conclude about the Federal Reserve's ability to reduce output gaps in the economy? Can the Federal Reserve really "control" aggregate expenditures and income in the economy? Explain.
  answer: The Federal Reserve, through its ability to influence the money supply and interest rates, can affect aggregate expenditures in the economy, which in turn causes the equilibrium level of output to increase or decrease. In this way the Federal Reserve can reduce or eliminate output gaps in the economy. However, the Federal Reserve does not "control" consumer and investment spending, the two interest-rate sensitive components of aggregate expenditures. Rather, the Federal Reserve relies on past history and economic models to help it predict the effects of an increase or decrease in interest rates on aggregate spending. Because it does not control consumers' or firms' spending decisions, the Federal Reserve cannot predict with certainty whether a given change in interest rates will succeed in closing a particular output gap.