Question

If you were a policy maker and were faced with the issues below, determine whether AD or AS should be increased, decreased, or left alone to correct the economy, and identify what you would recommend be done (increase/decrease; buy/sell) using each tool for the scenario (answer on each line) to accomplish this. Suppose that the natural rate of unemployment is 4%.

#3 Unemployment = 10%; Inflation = 10%

Action -- Increase/Decrease AD/AS??

Fiscal Policy --

Business Taxation  

Household Taxation

Government Expenditures

Monetary Policy --

OMO

Discount Rate

Reserve Ratio

Explain logic

Answer 1

In this economy, there is high inflation and high unemployment. This is called Stagflaiton, and is a rare occurence. This happened in the US in 1970s.

The aim is to reduce inflation but also to increase jobs (hence reduce unemployment). Usually, these two go in opposite direction. In the US, that was resolved by having initial pain. Inflation control was targeted and led to loss of jobs and contraction for some time. But then growth returned, without the inflation. We will follow the same method- trying to decrease inflation without affecting the demand as much as possible.

Fisal policy- Neither increase nor decrease. Keeping fiscal policy same will ensure that inflation remains same but not demand doesnt get affected much.
Business Taxation- Decrease. Decrease business taxes will enhance production and increase jobs.
Household taxation- Neither increase nor decrease. Household taxation cant be decreased as that would lead to inflation, but increasing it would dampen demand. Hence keeping same.
Government Expenditure- Keep same, Same reasoning sa fiscal policy.
Monetary Policy- Contractionary. Decreasing money supply will control inflation.
OMO- Sell. Will decrease money supply and hence decrease inflation.
Discount Rate- Increase. Will decrease money supply and hence decrease inflation.
Reserve Ratio- Increase. Will decrease money supply and hence decrease inflation.