## Principles of Economics: Problems * Macroeconomics * Aggregate Demand and Aggregate Supply II

Suppose that it is June 2015 and you are working in New York forecasting the 2016 economy for Medium-Sized Hedge Fund Named After a Local Geographic Feature. Your bosses want you to inform them about the likely shape of the economy in 2016--not just the total level of real GDP Y, but the levels of consumption spending C, investment spending I, government purchases G, and exports X. Your baseline forecasts--which you get via a painfully-expensive subscription to Mississippi Valley Forecasters--are that for 2016 real GDP (measured in dollars of 2009 purchasing power) and its components will be:

• X: Exports: $2.3T • G: Government Purchases:$3.0T
• I: Investment Spending: $2.9T • C: Consumption of Domestically-Produced Commodities:$8.9T
• Y: TOTAL: $17.1T Suppose that you believe the marginal propensity to consume cy= 0.6667. 1. Suppose that in June 2015 President Obama, the Democratic leaders in Congress, and the Republican leaders in Congress suddenly reach agreement on a large infrastructure investment program to rebuild America. They pass a low boosting government purchases G in 2016 by$300 billion. Assuming that you believe the Federal Reserve will not change the path of interest rates in response to this policy shift, what do your forecasts of X, G, I, C, and Y for 2016 change to?

2. Suppose that between today, March 2014, and 2016, the view of the Federal Reserve changes: by 2016 is no longer believes that there is significant slack in the labor market and no longer believes there is a significant gap between actual real GDP and potential output. As a result, if ever the Federal Reserve forecasts that GDP will exceed potential GDP, it will raise interest rates in advance in order to reduce it back to potential. Suppose the Federal Reserve's forecasters are as smart as and think like you. And, last, suppose that when the Federal Reserve raises interest rates in order to reduce spending and production each dollar by which spending is reduced is divided, with $.25 in reduced consumption spending because of lower household wealth due to the higher interest rates,$.25 in reduced exports because of a higher value of the currency due to the higher interest rates, and \$.50 in reduced business investment spending because of the higher interest rates. What now is your forecast of the effects on the economy of the infrastructure investment program?

3. In the setup of part one, is the infrastructure investment program likely to be good policy? Why or why not?

4. In the setup of part two, is the infrastructure investment program likely to be good policy? Why or why not?