In a closed agricultural economy, a new water source has been discovered that is expected to provide a steady supply of water for the crops and thereby increasing expected output in the future. Assuming no other changes in the economy, answer the following questions using the Classical IS-LM model.
(a) What market(s) is/are effected in the Classical IS-LM framework?
(b) Describe in words what the general equilibrium is.
(c) What happens to bring the economy back to general equilibrium?
(d) Draw the movements in the Classical IS-LM framework. Label your graph carefully.
(e) What happens to the real interest rate and output?
(f) What happens to employment?
(g) What happens to savings, investment, and consumption?
(h) Suppose you are a Classical economist and the Chairman of the Federal Reserve Board, who’s goal is to stabilize the economy’s output (i.e., keep the economy at the full-employment equilibrium). What would be your policy recommendation? Why?
(i) Draw the movements of the same shock, assuming it is unanticipated, under the misperceptions theory in the AD-AS framework. Clearly label your graph.
(j) What is different about the AD-AS model based on the misperceptions theory compared with the Classical AD-AS model? Why?
(k) Describe the short-run and long-run equilibriums, if any.