Principles of Economics

Running head: PRINCIPLES OF ECONOMICS
Principles of Economics
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ECONOMICS OF PRINCIPLES1
Table of Contents
Question 1..................................................................................................................................2
Question a...............................................................................................................................2
Question b..............................................................................................................................3
Question 2..................................................................................................................................3
Question a...............................................................................................................................3
Question b..............................................................................................................................4
Answer c.................................................................................................................................5
Answer d................................................................................................................................6
Answer e.................................................................................................................................7
Question 3..................................................................................................................................8
Question 4..................................................................................................................................8
References................................................................................................................................10

ECONOMICS OF PRINCIPLES2
Question 1
Question a
The above figure presents Keynesian cross diagram. In the above figure, the 450 line
intersects the aggregate expenditure line below the full employment level of GDP. The
equilibrium GDP of the economy is 500. The full employment GDP also represents potential
GDP of the economy. As GDP at equilibrium is less than the potential GDP, there is a
recessionary gap in the economy. As GDP at equilibrium is below the full employment level,
this implies firms are not hiring all the available workers (Goodwin et al. 2015). This in turn
results in a high unemployment. The recession may be caused due to a fall in consumption,
increase in saving, decline in investment, fall in government expenditure, increase in tax,
increase in imports or fall in exports. The economy that is in equilibrium along with a
recessionary gap may stays there and experiences a high rate of unemployment.

ECONOMICS OF PRINCIPLES3
Question b
Keynesian solution to a recessionary gap is to adapt an expansionary fiscal policy.
Keynes suggested that an expansionary fiscal policy can be taken in the form of direct cut in
tax rates which helps to increase consumption and investment shifting the aggregate demand
curve outward. Government could make additional expenditure on roads, housing or other
public goods (Uribe and Schmitt-Grohe 2017). Any form of additional government spending
or cut in taxes increases aggregate expenditure shifting the curve to the right. In response to
such a policy, the economy reaches to a new equilibrium where actual GDP equals the
potential GDP.
Question 2
Question a
The increase in official cash rate is a part of contractionary monetary policy. An
increase in official cash rate increases other interest rate in the economy. Interest rate is the
cost of investment. An increase in interest rate thus lowers the level of investment.
Investment is one important components of aggregate demand. A decline in investment
causes a decline in aggregate demand. The aggregate demand curve shifts to the left (Heijdra
2017). Given the aggregate supply, a decline in aggregate demand shifts short run
equilibrium to the left. As a result, equilibrium price falls from P* to P1 and that of
equilibrium GDP declines to Y1.