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

Suppose that the aggregate supply curve for 2016 is given by:

• P = 1.10 for Y < $18.9T (2009) • P > 1.10 for Y =$18.9T (2009)
• No possibility of Y > $18.9T (2009) With the price level in 2015 being 1.08, so that expected inflation over the year from 2015 and 2016 is 1.85%. 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 Larry Meyer and company's Macroeconomic Advisors http://www.macroadvisers.com/tag/larry-meyer/--are that for 2016 real GDP (measured in dollars of 2009 purchasing power) and its components will be: • X: Exports:$2.3T (2009)
• G: Government Purchases: $3.0T (2009) • I: Investment Spending:$2.9T (2009)
• C: Consumption of Domestically-Produced Commodities: $8.9T (2009) • Y: TOTAL:$17.1T (2009)

and your estimate of the marginal propensity to consume cy=0.667.

Suppose that in March 2015 President Obama, the Democratic leaders in Congress, and the Republican leaders in Congress suddenly get into furious negotiations over a large infrastructure investment program to rebuild America. Assume that you believe the Federal Reserve will not change the path of interest rates in response to this policy shift.

1. Thanks to the Supreme Court's campaign-financing decision of April 2, 2014, your principals find themselves besieged by phone calls from legislators of both parties begging them to commit massive donations to their campaigns so that they can protect America from the other party. In the course of these phone calls, the legislators ask for advice as to how large the infrastructure investment program should be in 2016. What do you tell your bosses they should answer? Why?

2. Total spending--nominal, not real--in the baseline scenario for 2016 is projected to be equal to P x Y = 1.1 x $17.1T (2009) =$18.8T (nominal). Suppose that the government in fact enacts an even larger infrastructure spending program than you calculated as optimal in (1), so that total nominal spending P x Y in 2016 is going to be \$22T (nominal). What do you forecast the price level will be in 2016? What do you forecast the inflation rate will be in 2016?

3. If the Federal Reserve decides to raise interest rates in order to keep inflation from being as high as you calculated in (2), what should it aim to make nominal spending in 2016 in order to keep inflation from 2015 to 2016 under 3%?