Question

Question 2: Application of Basic AD/AS Model to Fiscal Policy. [Suggested writing time: 17 minutes] Suppose due to an impeachment you are the newly elected President of the United States (US). You, with your prudent set of economic advisors, are reviewing the following hypothetical economic data in 2019 to 2020:

Real GDP per capita growth rate = -0.2%

Unemployment rate = 6.8%

Inflation rate = -1.0%

a. Determine what phase of the business cycle the US economy is likely to be experiencing in 2019 to 2020. Provide specific reasons for your answer. b. Use a well-labelled AD/AS diagram to show the position of this economy in 2020. Explain how the US government, using appropriate fiscal policy, might boost the economy back to the long run, full-employment GDP equilibrium. Draw the AD curve shift(s) associated with this policy on your diagram.

Answer 1

a.) The phase of the business cycle the US economy will be in is in recessionary phase or in the business cycle. Factors that influence this reasoning are, firstly, the per capita growth rate of real GDP is negative, which could be corresponded to an overall negative growth rate of real GDP, and a negative growth rate of real GDP in two consecutive quarters is considered a recession. Secondly, the rate of unemployment is 6.8% which is higher than the natural rate of 4.7%. Thirdly, the inflation rate is negative, which means the prices are falling, and this tends to happen in recessions.

b.) Please refer to the diagram above. The aggregate demand curve will shift to the left from AD(2019) to AD(2020). This could be a result of the impeachment as the investment component could take a substantial hit due to the pessimistic sentiment in the market.

c.) The fiscal policy that needs to be employed in a recessionary environment is an expansionary fiscal policy. In an expansionary fiscal policy, the government will either cut taxes, increase government spending or both. Due to the direct and linear relationship shared by AD and its components, namely, consumption, investment, government spending and net exports any increase in any of these components will cause the AD to increase and shift to the right. Therefore a decrease in taxes will cause the consumption component of the AD to increase as disposable income increases. If the government increases spending, the government spending component of the AD increases causing the AD shift to the right. Therefore the government could use this policy to bolster the economy if the economy falls to output levels of Y20 at AD2020, and shift the curve to the right to AD* and output level Y*, this would push the economy towards full-employment GDP equilibrium.