Question

Consider AD, SRAS and LRAS for the economy of country Xantron.

1.1 Suppose Xantron is having real GDP lower than $1 million in a short-run situation, compared to Xantron's potential GDP. Give an example what might have caused this kind of situation in Xantron that could be mitigated by Monetary Policy. What kind of monetary policy could be useful for the economy of Xantron to restore potential GDP? Explain short-run and long-run dynamics ( changes/shifts/movements relating to AD, SRAS, LRAS, changes in price level, output level etc. associated with this particular Monetary policy)

1.2 Suppose in a short-run situation Xantron has real GDP exceeding potential GDP by $1 million. Give an example what might have caused this kind of situation in Xantron that could be mitigated by Monetary policy. What kind of Monetary policy could be useful for the economy of Xantron to restore potential GDP? Explain short-run and long-run dynamics (changes/shifts/movements relating to AD, SRAS, LRAS, changes in price level, output levels etc. associated with this particular Monetary policy)

Answer 1

Suppose the government of Zee Increases the lump sum taxes, T while the Governement Expenditure remains unchanged at G.

Intially, budget was balanced. Increase tax T while keeping G unchanges would lead to Budget Surplus.

Now National Saving= Private saving+ Public savings

National Saving= S+ T-G

If T Increases, National savings Increases.

In the market for loanable funds, the supply curve of loanable funds shifts to the right. The interest rate, as a result of this, Decreases as shown in the diagram below. And since interest rate Decreased, the investment spending in the Economy will increase. Level of Debt in the economy would go down.

3.2) In the short run, the Aggregate Demand curve would shift leftwards in the AS-AD framework because an increase in tax reduces the disposable income and thus output and price level in the Economy.

In the long run, however, the labour maeket adjustment takes place and the employement remains at full level. The Economy again is driven back to the full employement level of Output but the price level is even lower than even the Short-run level.

The dilemma faced by this government is that this policy of fiscal contraction, may lead to price steep too low, lower than what might have been planned while the level of Output remains same in the Economy. In the long run, only price level goes down which can create ruckus in the business expectation.