Assume Real GDP is at potential level initially and government is running a balanced budget. Now assume that the stock market is seeing a boom and causing a affecting real wealth of households.
a. What is the effect of this change on the economy's Real GDP, price level and unemployment in the short run?
b. What is the effect of this business cycle shock on the budget balance. Explain to get full credit.
a. The increase in real wealth due to the stock market boom will have a positive effect on the economy's Real GDP, price level, and unemployment in the short run. Here's how:
1. Real GDP: The increase in real wealth of households will lead to higher consumer spending. As households feel richer, they are likely to increase their consumption of goods and services, stimulating economic activity. This increased spending will contribute to an increase in aggregate demand, leading to an increase in Real GDP.
2. Price Level: The increase in aggregate demand fueled by higher consumer spending can create upward pressure on prices. As people have more money to spend, businesses may be able to charge higher prices for their goods and services. This can lead to inflationary pressures and an increase in the price level.
3. Unemployment: The increase in consumer spending and aggregate demand can also have a positive effect on employment levels in the short run. As businesses experience higher demand for their goods and services, they may need to hire more workers to meet this increased demand. This can result in a decrease in unemployment rates.
b. The business cycle shock caused by the stock market boom can have an impact on the budget balance. Here's how:
1. Increased tax revenue: As people experience gains in their stock market investments and real wealth, they may be subject to higher capital gains taxes. The government can benefit from this increased tax revenue, leading to higher revenue inflows.
2. Increased government spending: The increase in real wealth can also lead to higher federal tax revenue, which may give the government more room to increase spending in the short run. This could include increased spending on public goods, infrastructure, or social programs.
3. Potential deficit or surplus: Whether the business cycle shock affects the budget balance in the short run will depend on the magnitude and timing of the increase in tax revenue and government spending. If the increase in tax revenue outweighs the increase in government spending, there could be a surplus in the budget. Conversely, if the increase in government spending outweighs the increase in tax revenue, there could be a deficit.
It's important to note that these effects on the budget balance can also be influenced by other factors such as government policies, economic conditions, and fiscal discipline. The overall impact on the budget balance will depend on the specific circumstances of the economy.