Assume an economy is closed. According to classical economic theory, explain wha

Question

Assume an economy is closed. According to classical economic theory, explain what will be the long-run effects of the increase in government purchases of the late 2000s. You need to present and discuss a formal model in detail for this question and then explain the implications of the model in the context of the question, i.e., explain the effects of expansionary fiscal policy in the model. You may want to organize your answer around these three parts: A) Aggregate Supply/Output (includes a discussion of the determinant of the level of output and the effect of fiscal policy on output in the long-run B.Aggregate Demand/Real expenditures (includes a discussion of components of expenditures, their determinants, and the effect of fiscal policy on expenditures and the composition of expenditures). C. Loanable Funds Markets (includes a discussion of the determinant of the interest rate in loanable funds market and the effect of the fiscal policy on the real interest rate in the long run). Please include a graph if possible.

Explanation / Answer

Construction of the model

A)

Classical economists believed that wages and prices adjust rapidly to any change that happen in the market and there is always full employment in the economy. This would mean that producers will always be willing to supply any quantity that has been demanded by the consumers.

Hence, the AS curve is perfectly inelastic i.e. parallel to the y-axis.

B)

The aggregate demand curve AD, which exhibits a negative relationship between the price level and the output (income) level, can be drawn using the basic IS-LM model.

Consider that for any given level of money supply, the price level rises. With higher price level, the supply of real money balances falls and thus the LM curve shifts upwards. This raises the equilibrium rate of interest and reduces the level of output and income.

The aggregate demand curve AD plots this relationship between falling income and rising price level. This explains why the aggregate demand curve AD is downward sloping: to restore equilibrium, a higher price must cause a reduction in the equilibrium level of income.

In fiscal expansion, AE shifts to the right. Income and consumption rises. Wages and prices are flexible so they rise instantly to keep the economy on its potential level.

C)

In the market for loanable funds, equilibrium interest rate is determined when the supply of loanable funds (Savings) equilibrates the demand for loanable funds (Desired investment). Usually, the supply of loanable funds is assumed to be fixed (unrelated with the interest rate).

Demand for loanable funds is determined by the demand for investment from both purposes: residential and business.

If government spending increases, then investment spending falls in the short run due to crowding out . If the government announces investment tax credit tax for business investment only, then the demand for business investment will rise. Hence total investment shifts out.

In the long run, market for loanable funds has unchanged level of investment, and a higher interest rate.

With time, interest rate rises from thus moving the economy from point B to point C. Higher interest rate discourages both types of investment.

The net effect is a fall in the equilibrium investment and rise in equilibrium interest rate.

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