Question

2. Suppose you serve as an economist on the President’s Council of Economic Advisors (CEA), and the President has asked the CEA to inform him on potential policy responses to a recession the Country is currently experiencing. Your boss, the head of the CEA, feels it would be a good idea to explain both “models” of the macroeconomy to the President in some detail, and has asked you to write a response to the questions below in the most straightforward way possible: A. Which policy tool does the Federal Reserve use to conduct monetary policy most of the time? How would the Fed use this tool to fight a recession? Explain your answer. B. What is fiscal policy? What are the two ways for government to enact expansionary fiscal policy? Explain. C. Use a graph to illustrate why Keynesian Model economists believe monetary policy or fiscal policy can stimulate economic growth in both the short and long run. (HINT: Your graph should show short run equilibrium output changing as a result of the government’s action.) D. What is the Keynesian model concept of the “multiplier”? Discuss the logic behind the Keynesian multiplier, and identify the fiscal policy action that will create the largest multiplier effect. E. Why do Classical economists believe that fiscal policy is not just ineffective, but actually harmful to the economy? F. Why do Classical Model economists believe that monetary policy is ineffective and potentially harmful to the economy? Give at least one reason (We discussed two reasons, bonus possible if you can correctly give/explain both).

Answer 1

A. Most of the time Fed uses open market operations to conduct monetary policy operations which involves purchasing or selling government securities in the open market. In the times of recession, the Fed will have to increase the level of money supplied in the economy which it does by purchasing government securities in the open market.

B. A fiscal policy involves change in the government expenditure and level of government taxation in the economy. The two ways available with the government to enact expansionary fiscal policy involves increase in government expenditure and fall in the level of government taxation.

C.

D. Keynesian model concept of the multiplier states that output in the economy changes by a multiple amount with the change in autonomous expenditure in the economy involving changes in government expenditure, investment spending or autonomous consumption. The main logic is small changes in government's fiscal action have a large multiplier effect on the economy. The fiscal policy action that has largest multiplier effect on the economy is changes in government's expenditure. Increase in government expenditure leads to increase in the level of the national output by 1 / 1 - MPC.