Question

Using the model that predicts the inflation and unemployment rate, show what happens when there is a decrease in aggregate demand, and then the government conducts perfect counter-cyclical policy (before expectations adjust)

Answer 1

A countercyclical policy refers to the policy which raising government spending or reduce taxes at the time of recession and increases taxes or reduce spending at time of boom.

A fall in aggregate demand is the indicator that the economy is in a recessionary period. There are high unemployment rates and low inflation as given by the negative relationship between inflation and unemployment.

If the government conducts a countercyclical fiscal policy, then it will either raise government spending or reduce the taxes. Increased spending increases the flow of money and raises the purchasing power of the general public.

As a result, people start purchasing more goods and services. Aggregate Demand in the economy increases so much so that the recessionary gap is closed.

The perfect policy will lead to full crowding out effect.

The unemployment rate comes back to the natural rate of unemployment and the negative relation between unemployment and inflation is vanished. The Phillips curve becomes vertical.

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