Question

Suppose a closed economy (economy that does not engage in international trade) is described by the following table.

Year	Potential GDP	Real GDP	Price Level
1	$1600 billion	$1600 billion	100
2	$1650 billion	$1620 billion	109

a. What problem will occur in the economy in Year 2 if no policy is pursued?

b. Describe the fiscal policy tools that could be used to combat the problem. Carefully explain all steps in the link between policy and outcomes. What impact will this policy have on the various components of the aggregate expenditures? What will happen to the real GDP and Price level as a result of these policies?

c. Describe the monetary policy tools that could be used to combat the problem. Carefully explain all steps in the link between policy and outcomes. What impact will this policy have on the various components of the aggregate expenditures? What will happen to the real GDP and Price level as a result of these policies?

d. Will your answers to (b) and (c) change if this was an open economy. In what way?

Answer 1

a) In year 2, the Potential GDP when the economy is fully employed is $1650 billion, whereas the actual real GDP is $1620 billion. Since the actual Real GDP falls short of the potential Real GDP, it would lead to a negative output gap in the economy. This means, there would be a Contractionary or Recessionary gap equivalent to (-) 30 billion. If no policy is persuaded, the economy would experience a prolonged recession with low income and high unemployment rates.

b) To combat the problem, the government can implement an expansionary fiscal policy by using either of the two tools :

o Increase in Government Spending (G): The government can increase spending by investing more public welfare schemes, healthcare, infrastructure, transportation, etc. With such investment, the government is able to generate greater employment opportunities in the economy. As more labor is employed, aggregate production and aggregate income level rises. Rise in income levels induces households (which are the part of the newly employed labor force as well as the existing employed) to increase spending, that results in an increased aggregate demand. As spending level rises, output and income are further increased in response to higher aggregate expenditure due to the multiplier effect.

o Reduction in Taxes (T): If taxes are reduced (either lump-sum or the tax rate), it increases the aggregate disposable income (Yd = Y-T) in the economy. With more money in the pockets, households and business firms are able to increase their consumption (C) and investment spending (I), which results in an increase in aggregate demand.

Bothe the fiscal policy tools mentioned above helps in boosting the aggregate demand of the economy and graphically shifts the aggregate demand curve towards right. As a result, the prices level rises and the real GDP increases, moving nearer to the full employment level/potential real GDP.

c) To combat the problem, the central bank of the economy can implement an expansionary monetary policy i.e. increasing the money supply by using either of the following tools:

1. Lowering the policy rate

2. Reducing Required reserve ratio

3. Exercising open market operations by purchasing government securities

In all of the above cases the money supply in the economy increases which leads to a reduction in the overall interest rate. Lower interest rates means borrowing becomes relatively cheaper. Households for example can make more borrowing to purchase a new car or a new house. Similarly, business firms for example can borrow more to invest in new pants and machinery and exercise expansion. Thus, lower interest rates increases consumer and business confidence which induces them to increase consumption expenditure ( C) and investment spending ( I) respectively. Greater aggregate spending results in an increased aggregate demand and graphically shift the aggregate demand curve towards right. As a result, the prices level rises and the real GDP increases, moving nearer to the full employment level/potential real GDP.

d) If the economy is assumed to be an open economy another component of aggregate demand that is affected is Net Exports (NX), which is the difference between a country’s exports (X) and imports (M).

Fiscal Policy Effect:

As explained above an increase in the government spending creates a multiplier effect in the economy; however the multiplier in an open economy is smaller to the multiplier under a closed economy. Thus, increase in output due to increased government spending is lower in an open economy as compared to under a closed economy. This can be explained as below:

- Imports are an increasing function of income (M = mY, where m is the marginal propensity to import). As government spending increases or tax is reduced, consumers with higher income levels demand more of both domestically produced goods as well as imported goods. By spending a portion of their increased income on imports, some of the positive effect on domestic output is lost.

- Considering the IS-LM framework, an increase in G or a decrease in T leads to a rightward shift in the IS curve. With an unchanged LM curve, the interest rate rises. Higher interest rate induces investors (both foreign and domestic) to demand more of domestic currency that leads to an exchange rate appreciation. Stronger currency makes the domestic export basket less competitive and causes the net exports to fall. This causes the aggregate demand to fall that lowers the aggregate income levels. Thus, a fall in income due to fall in net exports offsets a part of the increased income caused due to an initail expansionary fiscal effort.

Monetary Policy Effect:

As in case of fiscal policy, monetary policy too operates through the channel of net exports in case of an open economy. Here, under an expansionary monetary policy a lower interest rate not only boosts consumption and investment spending but impacts significantly on the trade balance of the economy.

- Lower interest rates lead to a decline in net foreign investment because domestic assets with lower returns become comparatively less attractive as compared to foreign assets. This makes the demand of domestic currency to fall leading to a nominal depreciation.

- A weaker currency makes the domestic goods relatively cheaper that leads to real depreciation. Due cheaper exports, the foreign demand of domestically produced goods rise i.e. exports rise leading to an increase in net exports.

- Net exports being a component of aggregate expenditure boosts the overall aggregate demand and further increased the real GDP.

Unlike the closed economy here two mechanisms take into effect due to reduced interest rates:

1. Increase in Consumption ( C ) and Investment (I)

2. Increase in Net Exports (NX)

Both these mechanisms do not offset each other; rather they reinforce each other by strengthening the real GDP of the economy.