Question

Daw a graph.

The US has 1% annual inflation and 10% unemployment. Apply Fiscal Policies.

Show the application of the policies on the following, in this order:

Production Possibilities Curve (before = the situation, after = policies applied)

Aggregate Model (before = the situation, after = policies applied)

Money Market (as the policies are applied)

Loanable Funds (as the policies are applied)

Investment Demand (as the policies are applied)

Answer 1

USA has inflation at very low level but unemployment is high and hence expansioinary fiscal and monetary polices can be used so that aggregate demand shifts right and real GDP goes up and more jobs are generated.

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 as shown in figure below:

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. Equilibrium shifts from earlier a to b, It can be inflationary if all resources are fully used and there is no spare capacity and if AS shifts right then to point c which is like shifting LRAS and PPC to right.

Supply side policies: This policy focuses on aggregate supply. It has two types- market based and interventionist based. market based policy focuses on incentives for businesses, labor market reforms and encouraging competition. Interventionist based policy focuses on human and physical capital.

This also helps PPC to shift right so that economy has more potential now.

When there is more money in the market (as a part of expansionary monetary policy) then as supply shifts right, interest rates go down from i1 to i2. Lonable funds supply will also go up with people earning more. As interest rates go down investment will also go up.