On December 6th 1917, an explosion in the Halifax harbour caused by the collisio

Question

On December 6th 1917, an explosion in the Halifax harbour caused by the collision of two ships, one carrying explosives, killed 4 percent of the population of Halifax and injured around another 20 percent of the population, including leaving 2 percent of the population with serious eye damage or even blindness from the flying glass. Assuming a closed economy, use an IS-LM-FE diagram and all other relevant diagrams to show what would happen if this decreased the working age population (ignore any possible impact on future wealth or capital). Show and discuss what happens to output, the real interest rate, the price level and real wages

Explanation / Answer

Answer:

IS/LM/FE: Increase in government spending.

Consider the economy initially in general equilibrium with r* and full employment output Y*. In general equilibrium the labor market is in equilibrium, the goods market is in equilibrium (aggregate demand = aggregate supply) and the money market is in equilibrium. The initial price level is given by let suppose as P0. Now suppose the government increases its spending from G0 to G1. This increases the aggregate demand for goods and the IS curve shifts up and to the right. The level of demand is determined by the intersection between IS and LM and this is denoted Yd. At the higher level of government spending the aggregate demand for goods is greater than the aggregate supply of goods, Y*. Firms will see their inventory of goods fall and they will respond by increasing prices. Also, workers will bargain for higher nominal wages to keep their real wage constant. As overall prices and wages rise, the LM curve will shift up and to the left and the real interest rate will rise. As r increases, consumption and investment falls as we move along the IS curve toward the new general equilibrium let suppose r 1. At the new equilibrium, output is again Y* but the real interest rate and the price level are higher. Also, the higher amount of government spending has crowded out some private consumption and investment expenditure due to the higher real interest rate. The end result of the increased level of government spending is no increase in real output but the composition of demand has changed: more government spending and less private spending. This will lead to increase in captal inflow and as a result net export will fall as import rises. The real exchange rate will also fall.

FALL IN WORKING AGE POPULATION

Due to fall in working age population the FE curve which is vertical straight line at equilibrium will fall and this curve will shift left. Due to fall in working age population there will be fall in labou supply. As a result of this aggregate supply will fall than aggregate demand. Due to this there will be increase in price level. This will shift the LM curve to the left because real money supply will fall. Due to rise in price level there will be rise in wage rate also. As r rises this will induce fall in consumption and investment. So at new equilibrium there will be fall in output(Y), employment(N), real wage rate (W) and consumption(C).

Related Questions

Navigate

• Browse (All)
• Browse O
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.