posted by Sarah on .
2. The economy is in a recessionary gap, wages are inflexible downward, and there is complete crowding out. Which of the following is consistent with this state of affairs?
a. The economy will soon self-regulate and produce Natural Real GDP.
b. Expansionary fiscal policy will be effective at removing the economy from the recessionary gap.
c. If expansionary fiscal policy is implemented, the AD curve will shift to the right and eventually the price level and Real GDP will rise.
d. b and c
e. none of the above
I found out that the answer is e. Why is this the case, and what is complete crowding out?
First, complete crowding out: In the economy, there is some supply of loanable funds. If government borrows, from that supply of funds, so it can spend on some fiscal stimulus program, interest rates will rise, which will cause a decline in private investment. That is government spending "crowds out" private investment. In complete crowding out, any increase in government spending will be offset by an equal decrease in private investment. Ergo, fiscal policy is useless.
So, with complete crowing out, you can eliminate answers b and c (and therefore d). Next with inflexible downward wages, the economy cannot regulate out of a recessionary gap. So eliminate a. That leaves e.
complete crowding out means that any increa