Question

Fiscal Policy

For each of the event below, show the short-run effects on output, price and unemployment and explain how the Fed should adjust the money supply and interest rates to stabilize output   

A. President Bush’s tax cut the individual income tax by $2000 per household in 2003.

B. Federal government issues the treasury bonds to finance the war in Iraq, and sell them to U.S citizens.

C. Illinois state government increases income tax for the residents in Illinois to pay for education and pension deficits.

Answer 1

A. This will reduce the consumption spending of the citizens and hence reduce the aggregate expenditure in the economy. This will result in decrease in the output, price and employment in the economy. To counter this, the Fed can reduce the interest rate which will increase the investment spending and aggregate expenditure. This will then stabilize the output.

B. In this case, the govt borrows from citizens. Thus, overall money supply in the economy will reduce. This could result in an increase in interest rates. As interest rates increase, the cost of borrowing increases. This will decrease aggregate spending as investment expenditure will decline. The output and price level will decline. The unemployment will increase with decrease in spending. The Fed can increase the money supply by reducing interest rates and hence stabilize the output.

C. This case is similar to part A. The overall aggregate output and price will fall with an increase in income tax. The unemployment will also increase. To counter this, the Fed can reduce the interest rate which will increase the investment spending and aggregate expenditure. This will then stabilize the output.