MAE312 National Economic Policy - Assessment 1

Q3. Suppose real output is initially at its full employment level. Using Aggregate Demand (AD)—Aggregate Supply (AS) framework, discuss the short-run and long-run effects of a decrease in government expenditure on the price level, real output, nominal wage rate and real wage rate under the following three alternative assumptions:
i) nominal wages are fully flexible,
ii) nominal wages are relatively slow to adjust, and
iii) nominal wages are completely rigid.