Fiscal Policy – End of Chapter Problems 3. An economy is in long-run macroeconomic equilibrium when each of the following aggregate demand shocks occurs: a. A stock market boom increases the value of stocks held by households. b. Firms come to believe that a recession is likely in the near future. c. Anticipating the possibility of war, the government increases its purchases of military equipment. d. The quantity of money in the economy declines, and interest rates increase. Below, indicate what type of gap—inflationary or recessionary—that the economy will face after each of these shocks.

If the stock market booms, and this leads to an increase in the value of stocks held by household, total income held by households will increase, and this will in turn result in both more government revenue in the form of taxes, and more disposable income for private consumption and private saving.

These events will help the economy stay in macroeconomic equilibrium in the long-run.

Below, indicate what type of gap—inflationary or recessionary—that the economy will face after each of these shocks.

From this event (a stock market boom) an inflationary gap is likely to emerge, because the higher household income will lead to more spending, and if production of goods and services does not keep up with demand, the general price level of the economy will rise, in other words, inflation will increase.