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 band change it this was an open economy. In what way? 

Answer 1

a. If no policy is pursued there will be lower GDP which will co-exist with less than optimal level of employment. And there will higher price level because of supply shortage as output is low in comparison to the demand. Thus there will be stagflation as price level has increased and economic output is lower.

b. Fiscal policy tools of increase in government expenditure to increase the level of output so that employment is close to full employment level, decrease the tax rates for corporates so that firms spend more via investments in the economy, all these factors would lead to increase in real GDP. Aggregate expenditure consists of = C + I + G in a closed economy. Consumption would decline slightly in order to reduce the level of price level by increasing personal taxes slightly, otherwise inflation will go on increasing, investment and government expenditure will increase. Price level will decline as output will be higher than the demand.

c. Monetary policy tool of increasing the level of liquidity by easing access for corporate bonds, because as inflation is high, they can't increase interest rates, otherwise investment will be low in the economy which will reduce the output. Thus the MPC can buy corporate bonds, wherein funds are made available to the corporates to invest in the economy, which will increase the output and keep the interest rates at the same level or increase it, so that people save and don't spend more than necessary, thereby reducing the level of inflation and increasing real GDP.

d. If it was an open economy then the Net exports could have increased in order to increase the real GDP, thus the fiscal policy would have concentrated on giving export incentives, and the monetary policy could have changed via just focusing on the level of inflation by increasing the interest rates, so that price level declines, whereas real GDP could have increased because of higher exports and demand coming in from abroad.