Suppose a closed economy is described by the following table. Potential GDP $1800 billion, $1950 billion Real GDP $1800 billion, $1980 billion Price Level 100, 107

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Question (12 marks)

Suppose a closed economy is described by the following table.

Year         Potential GDP               Real GDP                  Price Level

                   $1800 billion                  $1800 billion                 100

2                 $1950 billion                  $1980 billion                  107

  1. What problem will occur in the economy in Year 2 if no policy is pursued? (2 marks)
  2. Describe the fiscal policy tools that could be used to combat the problem. Carefully explain all steps in the link between policy and What impact will this policy have on the various components of the aggregate expenditures? What will happen to the real GDP and Price level as a result of these policies? (4 marks)
  3. Describe the monetary policy tools that could be used to combat the problem. Carefully explain all steps in the link between policy and outcomes. What impact will this policy have on the various components of the aggregate expenditures? What will happen to the real GDP and Price level as a result of these policies?     (4 marks)
  4. Will your answers to (b) and (c) change if this was an open economy. In what way? (2 marks)

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