Question

Consider an economy that initially stays at its long-run equilibrium. Policy affects the economy with a one-period lag. Answer the following questions:

1. Use the 3-equations model and diagrams to provide a period by period explanation of how a negative aggregate demand shock lead to a deflation trap, where output and inflation are falling without limit. How can the government use fiscal policy to escape the deflation trap? Illustrate with diagrams.
2. Suppose that the current public debt is already quite large, explain the policy trade-off that the government faces. To implement its policy, the government can choose to finance through either borrowing or taxing. In the light of this trade-off, which one would you recommend between these two options. Why?

Answer 1

We can explain this question with the help of the IS-LM model.in this market is in equilibrium when all the four market is in equilibrium simultaneously.all the markets are commodity market,bond market,money market and labour market.and we know if three market are in equilibrium then the fourth market will also in euilibrium.but what happen if this equilibrium in one market breaks.we can analyse it with the help of the following diagramhere we can see initially the market is in equilibrium at A when IS and LM curve is cut each other.also the aggregate demand and supply curve also in equilibrium at E.the output level is Y1 and price level is P1.the employment level in the market is N1 getting W0 of minimal wage.but now for some reason aggregate demand falls.it may happen due to individuals propensity to save increases or they prefer to hold more money or anything else.then the aggregate demand curve shifts downward from AD1 to AD2.so the new equilibrium is at F.and to maintain this new equilibrium the LM curve shifts leftward from LM1 to LM2.so in this market also the euilibrium achieved but the output level falls from Y1 to Y2 and also the rate of interest increases from r1 to r2.but if rate of interest increases then also investment falls.so investment falls from I1 to I2.now if again we came back to commodity market here output level decrease and also price level decreases.and when price level decreases producers don't find it profitable to produce more.so they start to curtail production.and it has also a impact on the employment level.as output falls employment level also falls from N1 to N2.so the unemployment in the economy increases.and when unemployment increases then aggregate demand decreases furthur and the same process repeat itself.so economy is in a deflation trap.

To escape from this deflation trap government may increase his expenditure or may reduce taxes.but decrease in taxes is not so effective compare to increase in expenditure.so government has to borrow more and have to increase his expenditure.if the government increase his exprenditure in such a manner that push the aggregate demand back to AD1 then the equilibruim. will achive long run equilibrium again.