Question

Donald Trump promised a more aggressive fiscal policy with a large increase in spending and significant tax cuts leading to a much larger government (budget) deficit. The US economy was at near the full employment (the unemployment rate in the US was low below 5%), what do you expect will be the response of the US Central Bank in terms of changes to the cash rate? Explain.

Answer 1

Donald Trump promised a more aggressive fiscal policy with a large increase in spending and significant tax cuts leading to a much larger government (budget) deficit. This means that there will be a tremendous increase in the money supply in the economy and hence there will be increase in aggregate demand in the economy.

But since it is given that, the US economy was at near the full employment (the unemployment rate in the US was low below 5%), so though there may also be increase in the investment but the real output will not rise much because of the full employment and there will be a rise in wage rate as demand for labour will be more than supply, this will further increase the money in the economy and hence all of these factors will lead to increase in the rate of inflation.

So according to me, in response to the above mentioned conditions the US Central Bank may increase the cash rate so as to prevent any further increase in money supply. If cash rate is high, Commercial Banks will take less loans from Central Bank and hence provide less loans to people and hence money in the economy will not increase further.