Question

In: Economics

Initially a small open economy is in recession. The government implements expansionary fiscal policy by increasing...

Initially a small open economy is in recession. The government implements expansionary fiscal policy by increasing government spending. However, central bank worries about inflation and increase interest rate. Examine the effects of this policy combination on output, interest rate and the components of demand under flexible exchange rate regime(Hint:Useopen economyIS-LM model)

Solutions

Expert Solution

                                    The given condition states the dual policy implementation in an economy where the expansionary fiscal policy aimed at reducing the effects of recession in an economy further creates a worry of future inflation and forces the monetary authority to increase the interest rate. This case states that the dual policies ie; the fiscal and monetary policy is acting in the opposite direction which is expected to have serious impacts on the demand and output in an economy which is characterised by a flexible exchange rate as seen in the US economy.

                                    Fiscal and monetary policies represents the two ways in which the recessionary and inflationary situations of an economy is monitored. With the recessionary situations, as suggested, the government is forced to increase the spending in the economy as seen in the recent times, especially in the US economy which undertook a program that introduced almost 10% of its GDP in to the economy to overcome the recessionary menace that was caused by the pandemic. But it has to be understood that the government spending should be always restricted to bringing back the economy to its normalcy. Once the spending goes beyond the scope for which it was intended, it has the tendency to create further inflationary situations which would force the monetary actions like cutting down of interest rates as specified in the given case. The IS-LM model refers to the Investment-Savings and Liquidity preference-money supply model which states how the market for economic goods would interact with the money market in an economy. The intersection of the curve in such a graph would represent the short-run equilibrium point in an economy between the interest rates and the output in the economy.

                                    Liquidity, investment and consumption defines the analysis that is made by this method. The liquidity is determined by the size and velocity of the money supply and the consumption and investment defined by the decision making of individuals. The following are expected to be the major effects of this dual policy of an economy on the output, interest rate and demand in an economy

· With increased government spending, the investment patterns are expected to improve and with the increased interest rates, the consumption patterns are expected to decline with the increased savings pattern in the economy and hence it would have the potential to decrease the production rates in an economy.

· With reduced demand, the spending in such an economy is expected to be lower and this would again lead to decreased production patterns in an economy

· Thus, as a response to the decreased consumption patterns, the interest rates would be decreased which would give more access to credit facilities and thus would lead to improved investment and production patterns in an economy

· The above cycle is expected to continue further that would lead to an unstable economy.


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