Question

The two big tools which the government and the Federal Reserve can use to influence the economy are fiscal and monetary policy.  

Use the Aggregate Demand and Aggregate Supply model, under the following scenarios, what would be the appropriate fiscal policy and monetary policy response to return the economy to full employment GDP? You may assume that the economy starts at a full employment GDP equilibrium. Make sure you include what kind of state the economy is in after the change below.

1. A surge in consumer spending causes the aggregate price level in the economy to suddenly begin rising rapidly.

2. A sudden and unexpected decrease in investment in capital by firms.

3. Trade tensions cause foreign consumers to purchase fewer American exports.

Answer 1

(1) Higher consumption increases aggregate demand, shifting AD curve to right, increasing both price level and real GDP. This will cause an inflationary gap. To lower inflation, contractionary fiscal policy (lowering government spending and/or raising taxes) and/or contractionary monetary policy (open market sale of government securities and/or raising discount rate and/or raising reserve ratio) should be implemented.

(2) Decrease in investment decreases aggregate demand, shifting AD curve to left, decreasing both price level and real GDP. This will cause a recessionary gap. To boost aggregate demand, expansionary fiscal policy (increasing government spending and/or lowering taxes) and/or expansionary monetary policy (open market purchase of government securities and/or lowering discount rate and/or lowering reserve ratio) should be implemented.

(3) Fall in US exports will reduce US net exports, which decreases aggregate demand, shifting AD curve to left, decreasing both price level and real GDP. This will cause a recessionary gap. To boost aggregate demand, expansionary fiscal policy (increasing government spending and/or lowering taxes) and/or expansionary monetary policy (open market purchase of government securities and/or lowering discount rate and/or lowering reserve ratio) should be implemented.