Question

Suppose the U.S. economy faces a productivity slump, while at the same time the federal government begins spending a lot of money on defense and social programs (this is akin to what happened in the U.S. during the 1960s and 1970s). Assume wages are sticky in the short run.

a. For each of the following variables, state whether it rises or falls, or whether the impact is ambiguous, after the two events described above: real GDP growth rate, unemployment, and the inflation rate.

b. If the Fed was concerned about the inflation rate, what action would it take regarding open-market operations? What impact would this have on the federal funds rate and aggregate demand in the economy?

c. What challenge does the Fed face in bringing the economy back to the real GDP growth rate it had before the productivity slump and increase in government spending?

Answer 1

US economy faces a productivity slump, meaning the GDP is declining. The federal government begins spending more money on defense and social programs. Wages don't move and stay the same in short run.

a. Real GDP will grow because the government has increased expenditure, this will be the key driving factor for a rise in real GDP growth rate. Unemployment will fall as government has increased expenditure, which will drive up employment opportunities. Inflation rate rises as money circulated in the economy rises.

b. Fed would reduce the money supply in the economy, thus it will sell bonds to the market through open market operations, wherein money will be pulled back into the system. Federal funds rate would increase as the liquidity will be low in the economy, thus there will be greater demand for credit, which will drive up the funds rate. Aggregate demand would dry up as less money starts circulating in the economy.

c. It has the trouble of higher funds rate, which makes credit expensive, which reduces the chances of industry investing in new technology. Thus it has to sustain the economy, wherein the economy doesn't rely on government expenditure, but instead private consumption and sustainable growth which has to drive GDP.