Question

1. To fight a inflation

a) How should the government execute Fiscal Policy?

b) How should the Federal Reserve Bank execute Monetary Policy?

Make sure to include the appropriate graphs and analysis and how these policies each affect C,I, G, NX, AD, AS, P, Q, inflation, and economic growth.

Answer 1

INFLATION-

inflation is a situation where there is generally over full employment level in the economy and over utilization of the firms' resources which decreases the value of money in the economy.inflation leads to increase in the prices and after that people start demanding the non essential product,generally the imported product which lead to a deficit in BOP.

in the above diagram we can se how the economy is initially at EO and there is an inflationary gap between EO and EF.this gap can be eliminated through various steps undertaken by fiscal and monetary policy

generally government and central banks are authorized and capable as well to deal with such situation.

STEPS UNDERTAKEN BY GOVERNMENT-

government should take steps which would reduce the generation of income in the economy and would lead to decrease the marginal utility of money for the people and discourage the increase in the  investment.

• DECREASE IN PUBLIC SPENDING-government needs to decrease the construction work where the level of employment would decline and level of income would decline and so does income of the people.people would consume less and only spend the money on necessary goods.as a result there would be less demand in the economy.
• INCREASE IN TAX RATE-when government would increase the rate of tax in the economy then the net disposable income of the firm would decline and the Marginal utility of money would decline and they would produce less due to lack in the market demand and would not employ the workers in the economy.

STEPS UNDER TAKEN BY CENTRAL BANK-

• INCREASE IN BANK RATE-When there is inflation in the economy the bank would increase the bank rate,now the firm would have to pay higher interest rate on their borrowings and thus the investors won't prefer to invest in the new business.
• INCREASE IN MARGIN REQUIRED-when central bank would increase its margin requirement then the person would get less amount and bank would keep a greater share as security and net credit availability and cash flow would decrease in the economy.
• OPEN MARKET OPERATION/SELLING SECURITY IN THE MARKET -when banks would sell security in the economy the funds would be transferred from the public to the banks and thus there would be a lack of supply in the economy concerned with the funds.thus the supply would decline in the money market (as shown in the diagram) and the rate of interest would increase in the economy and people would not prefer to borrow at a higher and increased rate of interest.

as we can conclude the above steps and policies would

• limit the consumption
• decrease and limit the level of investment
• decrease in government expenditure and increase the over all revenue of the government
• price and quantity supplied would decline
• AD and AS would decline and the economic fluctuation would decline and economy would stabilize