Question

8. Two neighboring countries – Romulus and Remus – are experiencing a recession.

   1. Romulus’ government reduces its expenditure during the recession, while

      Remus’ government increased the supply of money in the economy. Explain

      which of the two policies will help the economy recover from the recession?

   2. How will Fiscal countercyclical policy affect the labor market in Remus if

      wages are downwardly rigid? Explain with a diagram.

   3. The unemployment rate in Romulus has been increasing. What will be the

      impact on the market if the government increases spending?

Answer 1

Romulus is following contractionary fiscal policy. Reumus is following expansionary monetary policy.

Recession is when real GDP growth is negative for six months. To avoid recession there should be enough aggregate demand in an economy. Aggregate demand should keep shifting right and it should be complemented by shift in aggregate supply as well so that economy potential goes up without inflationary impact on an economy.

This will be helped by both demand and supply side policies.

Demand side policies:

Fiscal policy is a policy controlled by the government and it has two tools: taxes and govt. spending. During recessions govt. decreases taxes and increases govt. spending which is called expansionary fiscal policy. During inflation govt. increases taxes and decreases govt. spending which is called contractionary fiscal policy. Monetary policy is a policy determined by central bank and has two tools; interest rates and money supply. When there is inflation and central bank wants to reduce over consumption in an economy then it increases interest rates and decreases money supply. This is called as contractionary monetary policy. When there is recession and central bank wants to boost economic activity then it decreases interest rates and increases money supply. This is called as expansionary monetary policy.

Expansionary policies create more aggregate demand, decrease unemployment. It can be inflationary if all resources are fully used and there is no spare capacity.

It is clear that Remus government is following a correct policy.

If wags are rigid then it will mean that costs of production may not come down and increased demand will cause inflationary impact. This is due to aggregate demand shifting right as shown in the figure below. Prices go up from P1 to P2.

Romulus government should increase spending as it needs to create more jobs. It will lead to aggregate demand shift rightdue to more consumer and government spending, and with higher GDP more jobs would be created in an economy. As shown in figure above, real GDP goes up from Y1 to Y2.