Change in overall investor confidence will impact the macroeconomy.
Here we will model an increase in investor confidence, holding all else constant, and use the AD/AS model to look at how fiscal policy can try and smooth out the business cycle. Our shock in this question will be investor confidence increases, holding all else constant. Let’s start with assuming the US was producing at the full-employment level of output (Yp) with an arbitrary price level (P) before the increase in investor confidence.
a. Represent the US economy at this point with an aggregate demand-aggregate supply graph. Label this initial equilibrium as point A.
b. Investor confidence increases like mentioned above. Assuming this was the only change in the economy, show how this affects the short run equilibrium in your diagram in part a. Label this new point as point B.
c. According to your diagram, is this economy in an expansion or a recession? Explain.
d. Assume the federal government decides to take action to try and move the economy back to long-run macroeconomic equilibrium. What are the two ways they would do this?
e. Would this be expansionary or contractionary fiscal policy?
f. Show how this policy affects the AD/AS model in part a. Label this new point as point C.