Question

The small open economy of Hundred Acre Wood has a fixed exchange rate and is initially in short-run equilibrium. An outbreak of COVID-19 occurs and as a result money demand rises AND autonomous consumption falls. Suppose policy makers would like to keep fluctuations in the unemployment rate as small as possible, this implies the best policy reaction would be to:

a) increase the money supply (only)

b) Increase taxes (only)

c) Increase the money supply, cut taxes and cut government spending on goods and services

d) cut government spending on goods and services and increases taxes (ONLY)

e) Decrease the money supply, cut taxes, and cut government spending on goods and services

f) Cut government spending on goods and services (only)

g) Decrease the money supply (only)

g) INcrease the money supply, increase taxes and increase government spending on goods and services

h) INcrease government spending on goods and services and/or cut taxes (only)

i) Increase government spending on goods and services; and revalue the fixed exchange rate

j) Cut taxes and revalue the fixed exchange rate

k) Decrease the money supply, increase taxes government spending on goods and services

Answer 1

The given small economy is in short run equilibrium. Now with the outbreak of COVID-19, money demand rises, and autonomous consumption falls. The policy makers would like to keep the fluctuations in the unemployment rate as small as possible. Since there is decrease in autonomous consumption, so there will be a decrease in demand for goods and services, which may result in the rate of unemployment to go down as the firms would have to slowdown the productions. So if the government want to maintain the unemployment level, it would have to go to its root cause and increase the autonomous consumption so that there is increase in demand for goods and services.

So in order to fulfill the increased demand for money and increase the demand of goods and services the government can increase the money supply and decrease the taxes. So that peoples disposable income increases. So option C. may be correct.