Question

Consider the following table for the U.S.

Year	Potential Real GDP	Real GDP	Price Level	Federal Funds Rate
2006	$15.3 trillion	$15.3 trillion	90.1	5.0%
2007	$15.6 trillion	$15.6 trillion	92.5	5.0%
2008	$15.9 trillion	$15.6 trillion	94.3	1.9%
2009	$16.1 trillion	$15.2 trillion	95.0	0.2%
2010	$16.3 trillion	$15.6 trillion	96.1	0.2%
2011	$16.5 trillion	$15.8 trillion	98.1	0.1%
2012	$16.7 trillion	$16.2 trillion	100.0	0.1%
2013	$17.0 trillion	$16.5 trillion	101.6	0.1%
2014	$17.3 trillion	$16.9 trillion	103.6	0.1%
2015	$17.6 trillion	$17.4 trillion	104.7	0.1%
2016	$17.9 trillion	$17.7 trillion	106.8	0.4%
2017	$18.2 trillion	$18.1 trillion	107.8	1.0%
2018	$18.5 trillion	$18.6 trillion	110.4	1.8%

a) Does the AD curve shift to the right more or less than the LRAS curve in a dynamic AD-AS model from 2006 to 2007? Explain why verbally.

b) Explain why the Federate Funds Rate declines from 2007 to 2009 using Taylor Rule. Based on the Federate Funds Rate data in the table, explain the limitation of monetary policy that is implemented through open market operation during severe recession.

c) Suppose a military operation that costs $200 billion in 2011 can help the real GDP recover to $16.2 trillion one year earlier. What is the minimal required MPC of households in the Aggregate Expenditure model if there is no tax wedge on household income? What if the tax wedge is 1/3 of the pretax household income? What is the difference between the answer based on the Aggregate Expenditure model and the answer based on the static AD-AS model.

d) There was large fiscal stimulus during 2009-2011. People believe that fiscal stimulus is more powerful in 2011 compared to 2017. Explain why this can be true using the Federal Funds Rate data.

Answer 1

a) The shift in the AD curve and LRAS curve in a dynamic AD-AS model is same from 2006 to 2007. The AD curve moves by $0.3 trillion (real GDP), and so does the LRAS curve (potential real GDP). This is so because while the price level has increased, the federal funds rate has remained constant at 5%.

b) Taylor rule states that Fed should lower the rates when GDP growth is slow and below potential. From 2007 to 2009, the real GDP was well below the potential GDP. In 2009, there was difference of $0.9 trillion. Thus, the Federal Funds rate declined from 5% to 0.2%.

This is basically an expansionary monetary policy followed by the Fed through open market operations during times of recession. The main drawback of this policy is the rising price level. As we can see, the price level increased from 90.1 to 95. In an economy where people's disposable incomes is taking a beating, such an increase in likely to draw into their savings.

c) Minimum required MPS of households in case of no tax wedge for households should be equal to the aggregate expenditure. With tax wegde, it should be equal to C + t. With a dynamic model, aggregate demand would reduce with tax wedge, moving the curve to the left; decreasing price level and output (real GDP).

d) During the fiscal stimulus of 2009-2011, Federal Funds rate was consistently falling. The gap between potential real GDP and real GDP was rising and the price level increasing. A falling interest rate was necessary to increase the investments in the economy, leading to more output.

In 2017 however, the gap between potential real GDP and real GDP had narrowed leading to increase in interest rates. Increased interest rates dampen borrowing for consumption and investment. It's more accurate to say that at this point, there was no need for fiscal stimulus.

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