Finally, we will continue to look at a shock from military spending, but now think of a more concrete example: the Unites States entering into World War 2 while still mired in the Great Depression. Before the U.S. entered the war, output was very low compared to the natural output and interest rates were close to 0% (classical liquidity trap). One way we might think of this is from the equations used above: d2 is infinitely large, so that b2d1/d2 is close to 0, and obviously b1 > b2d1/d2. Show how the IS-LM model can now be represented in a diagram. Show a point on the IS-LM diagram that represents where the economy is before entering into World War 2 (you can label this point A). What can you say about how the government spending shock (which increases the budget deficit) will affect investment? Now represent this scenario in the AD-AS model. Show the AD-AS diagram, with the initial point (point A) at Y < Yn, and then how the spending shock can move the economy back to the natural output. Given what you see, are you surprised that the United States was not able to escape the Great Depression until after World War 2? How could the normal market mechanism have failed to get us closer to the potential output?
Finally, we will continue to look at a shock from military spending, but now think of a more concrete example: the Unites States entering into World War 2 while still mired in the Great Depression. Before the U.S. entered the war, output was very low compared to the natural output and interest rates were close to 0% (classical liquidity trap). One way we might think of this is from the equations used above: d2 is infinitely large, so that b2d1/d2 is close to 0, and obviously b1 > b2d1/d2. Show how the IS-LM model can now be represented in a diagram. Show a point on the IS-LM diagram that represents where the economy is before entering into World War 2 (you can label this point A). What can you say about how the government spending shock (which increases the budget deficit) will affect investment? Now represent this scenario in the AD-AS model. Show the AD-AS diagram, with the initial point (point A) at Y < Yn, and then how the spending shock can move the economy back to the natural output. Given what you see, are you surprised that the United States was not able to escape the Great Depression until after World War 2? How could the normal market mechanism have failed to get us closer to the potential output?
final_2013ss2.docx