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?

Question

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?

Good question.

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

Answer 1

se in government spending will be completely offset by a decrease in private investment, essentially making fiscal policy ineffective in addressing the recessionary gap. This is due to the fact that when the government borrows from the supply of loanable funds, interest rates will rise, making private investment less attractive.

Now let's analyze each of the options:

a. The economy will soon self-regulate and produce Natural Real GDP.

With inflexible downward wages, the economy will not be able to self-regulate and move out of the recessionary gap. Wages being inflexible downward means that they do not decrease in response to lower demand, thus preventing the economy from reaching equilibrium on its own.

b. Expansionary fiscal policy will be effective at removing the economy from the recessionary gap.

Given that there is complete crowding out, expansionary fiscal policy would not be effective at addressing the recessionary gap, as any increase in government spending would be offset by a decrease in private investment.

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.

Again, because of complete crowding out, any attempts at expansionary fiscal policy would not lead to a shift in the AD curve, as the increase in government spending would be counteracted by decreased private investment.

d. b and c

As both b and c are incorrect, d is also incorrect.

e. none of the above

As none of the other options accurately describe the situation, the answer is e.