Question

Ms. Smart looks out of her office window on the 38th floor of the Central Bank of Fairytale. She just finished flipping through the Fairytale’s Economic Outlook report put together by the Policy Unit division of the Central Bank. In the report, consumer spending has decreased by 2% from the previous fiscal year, and the country’s real GDP dwindled by 3% from the previous year. The GDP of Fairytale was 3.0 billion Fairytale Dollars (F$) and F$2.9 billion in 2017 and 2018 respectively. At the same time, the consumer price index increased from 111 in 2017 to 115 in 2018. Forecasts from the Statistics Fairytale show that the population will continue to grow at 2.3% for the next two decades. This creates both challenges and opportunities for Fairytale. In 2001 huge deposits of gold were discovered in the southern part of the country. This discovery attracted investments and the economy grew rapidly between 2002 and 2014. During this period, the government invested heavily in research institutes, universities, and space programs. In 2015, gold mining firms started to declare losses. This was caused by the declining gold deposit, high costs of production and many lawsuits won by an environmentalist in the Southern part of Fairytale. The Chief Economist estimated that if all prices including nominal wages are fully flexible, real GDP of Fairytale in should be F$2.81 billion, everything else equal. Fairytale’s report shows that interest rates have been decreasing and nearly zero. The interest rate for 2017 and 2018 was 4% and 2% respectively. However, the demand for money has decreased drastically. The average household debt in Fairytale has increased by 20% in the last ten months. Major commercial banks have reduced lending facilities to both households and businesses. Ms. Smart understands the economy of Fairytale very well. She belongs to the school of thought that believes in government intervention in an economy. She has a Ph.D. in Economics from the National University of Fairytale, one of the best in the world. Mr. Free became the Prime Minister of Fairytale in 2019 and appointed Ms. Smart in January of 2020. His election campaign was sponsored by the Fairytale Society of Business, an association of business owners in Fairytale. Mr. Free was a staunch critic of the previous government’s policies centred on social housing, education, and narrowing income inequality. The previous government increased minimum wage from F$9.5 in 2017 to F$11 in 2018. The Fairytale Society of Business was against the minimum wage and believed it should be closer to the average wage of F$9. During his campaigns, Mr. Free promised to reform the tax system, especially the corporate tax. 2 Ms. Smart faces a huge task of providing economic policy advice to the Prime Minister. As she looked over her office window, her eyes struck a huge billboard advertisement for a major telecommunication firm. A sentence is inscribed on the board. She starred tensely at the board, the inscribed sentence reads – with people’s ideas, you can move the world. Answer the following questions: a) Describe the economic situation of Fairytale in FIVE words! b) Based on what you have learned in this course, what wrong assumption/conclusion can be made by Ms. Smart? c) Use the aggregate demand and aggregate supply curves to explain the impact of a contractionary and expansionary fiscal policy on Fairytale’s economy. d) When is Fairytale's economy in the short run or /and long-run macroeconomic equilibrium? e) Using only two graphs, explain how an expansionary fiscal policy could be used to restore normalcy to the economy of Fairytale. f) Using economic concepts state and explain the best policy that could be used to increase the money supply in Fairytale. g) Use the concepts of lags to explain the unanticipated effect of any policy action by Ms. Smart. h) Supposing you are the Chief Economic Advisor for Ms. Smart, propose two monetary policies and two fiscal policies? i) Using economic concepts state and explain the potential issues or barriers to your proposed policy. j) Determine the real interest rate in 2018. k) What is the percentage change in the real minimum wage? l) Do you agree with the arguments of the Fairytale Society of Business on minimum wage?

Answer 1

Key points from the case:

Consumer spending decreased by 2% GDP. CPI increased by 3.60%. GDP went down by 3.33%. Hence Real GDP is down again, population is also increasing.

2002-2014 was a rapid GDP growth. Now, demand side is suffering, even though interest rates are low there is no enough demand. Businesses complain of higher minimum wages. Current government is proponent of free economy and trying to reduce taxes.

a. Recessionary gap, low aggregate demand, increasing costs of production, government intervention needed, Real and nominal GDP.

b. Ms. Smart may think raising wages is a good initiative to achieve income equality but it disturbs labor market equilibrium. Government intervention may generate aggregate demand immediately.

c.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 and shift aggregate demand to right from AD1 to AD2 and shift real GDP from Y1 to Y2. It can be inflationary if all resources are fully used and there is no spare capacity.

d. Currently, economy is in recessionary gap. Gap between Y1 and Y2 needs to be closed for long run aggregate potential at Y2 to be achieved.Refer fig. below:

e. Already explained in part c.