Question

Recessionary or Inflationary Gap? Discussion Select & Address United States Treasury Department. Is a recessionary or inflationary gap bad for an economy? Have you ever wondered how the federal government and the Federal Reserve react to smooth out recessionary and inflationary gaps? In this activity, you will explore the concepts of fiscal policy and the attempts the U.S. government takes when the U.S. economy is in a recessionary or inflation gap. You will discuss the concepts of aggregate supply and aggregate demand to determine how the U.S. economy can work its way back to long-run equilibrium based. Locate a recent article (published within the last year) that discusses fiscal policy and whether the U.S. economy is in an inflationary or recessionary gap. You can use the Hunt Library, newspapers, new stations, or other credible sources to locate an article. Analyze the article and then address the following concepts in your discussion. Interpret recessionary and expansionary gaps within the economy. Explain the inter-workings of fiscal policy tools. State how taxation and government spending works. Differentiate between fiscal and monetary policy. Demonstrate the mechanics of discretionary fiscal policy within the Keynesian framework. Summarize your findings using at least 250 words and provide a minimum of one reference. Use current APA formatting to document your sources.odule 7 Recessionary or Inflationary Gap? Discussion Select & Address United States Treasury Department. Is a recessionary or inflationary gap bad for an economy? Have you ever wondered how the federal government and the Federal Reserve react to smooth out recessionary and inflationary gaps? In this activity, you will explore the concepts of fiscal policy and the attempts the U.S. government takes when the U.S. economy is in a recessionary or inflation gap. You will discuss the concepts of aggregate supply and aggregate demand to determine how the U.S. economy can work its way back to long-run equilibrium based. Locate a recent article (published within the last year) that discusses fiscal policy and whether the U.S. economy is in an inflationary or recessionary gap. You can use the Hunt Library, newspapers, new stations, or other credible sources to locate an article. Analyze the article and then address the following concepts in your discussion. Interpret recessionary and expansionary gaps within the economy. Explain the inter-workings of fiscal policy tools. State how taxation and government spending works. Differentiate between fiscal and monetary policy. Demonstrate the mechanics of discretionary fiscal policy within the Keynesian framework. Summarize your findings using at least 250 words and provide a minimum of one reference. Use current APA formatting to document your sources.

Answer 1

An inflationary gap is a macroeconomic concept that describes the difference between the current level of real gross domestic product (GDP) and the anticipated GDP that would be experienced if an economy is at full employment. This is also referred to as the potential GDP. For the gap to be considered inflationary, the current real GDP must be the higher of the two metrics.The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The inflationary gap is so named because the relative increase in real GDP causes an economy to increase its consumption, which causes prices to rise in the long run.

Inflationary gaps occur when aggregate demand is higher than the projected demand, which can be caused by two different things:

• A rise in aggregate demand. A rise in demand will naturally create a discrepancy between real demand and potential demand. Excess demand can be caused by a variety of things: lower unemployment, a rise in consumer confidence, an increase in government expenditure, or an increase in private investments.
• A fall in aggregate supply. A fall in supply will also naturally create a discrepancy between real demand and potential demand. Potential causes of supply decreases include increased tariffs, wage increases, or wartime (when facilities are used for war purposes instead of producing commercial goods

Inflationary gaps can be managed in two main ways to bring higher price levels into market equilibrium:

• Fiscal policy. Fiscal policies are policies enacted by the government to control the money supply. To manage inflationary gaps, governments can enact contractionary fiscal policies, which reduce the money supply and therefore reduce demand. These policies can include reducing government spending and increasing taxes.
• Monetary policy. Monetary policies are policies enacted by central banks to control the money supply. To manage inflationary gaps, banks can increase interest rates to make borrowing money more difficult, therefore reducing the money supply and decreasing demand.

The Fed has several tools it traditionally uses to implement contractionary monetary policy. It only does this if it suspects inflation is getting out of hand. Its first line of defense is open market operations. The Fed buys or sells securities, typically Treasury notes, from its member banks. It buys securities when it wants them to have more money to lend. It sells these securities, which the banks are forced to buy. That reduces their capital, giving them less to lend. As a result, they can charge higher interest rates.

That slows economic growth and mops up inflation.

Second, the Fed can raise the reserve requirement. That's the amount banks must keep in reserve at the end of each day. Increasing this reserve keeps money out of circulation.

Third, the Fed can raise the discount rate. That's the interest rate the Fed charges to allow banks to borrow funds from the Fed's discount window.

The Fed rarely modifies these two tools. Instead, it usually changes the fed funds rate. It's the interest rate banks charge for loans they make to each other to maintain the Reserve requirement. That's much easier for the Fed to modify. It has the same effect as changing the Reserve requirement and discount rate.

Former Chairman Ben Bernanke said the Fed's most important tool is managing public expectations. Once people anticipate inflation, they create a self-fulfilling prophecy. They plan for future prices increases by buying more now, thus driving up inflation even more.

Bernanke said the mistake the Fed made in controlling inflation in the 1970s was its stop-go monetary policy. It raised rates to combat inflation, then lowered them to avoid recession. That volatility convinced businesses to keep their prices high.

Fed Chairman Paul Volcker raised rates to end the instability. He kept them there despite the 1981 recession. That finally controlled inflation because people knew prices had stopped rising.

The next Chairman, Alan Greenspan, followed Volcker's example. During the 2001 recession, the Fed lowered interest rates to end the recession. By mid-2004, it slowly but deliberately raised rates to avoid inflation.

Greenspan told investors exactly what he planned to do, thus avoiding another recession. He reassured market investors, who kept investing and spending despite higher interest rates. The past fed funds fate tells you how the Fed managed the expectations of inflation.

In order to learn and understand fiscal policy or monetary policy it is important to whether an economy, no matter where it may be in the world, can self regulate, or whether it needs an outside influence in order to adjust. This is where Classical and Keynesian economics will come into play. If you are of the Keynesian school of thought, you believe that the economy needs your influence in order to correct itself. This correction can be in the form of fiscal policy.

Fiscal policy can be defined as government is actions to influence an economy through the use of taxation and spending. This type of policy is used when policy-makers believe the economy needs outside help in order to adjust to a desired point. Typically a government has a desire to maintain steady prices, an employment level, and a growing economy. If any of these areas are out of sorts, some type of fiscal policy may be in order.Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles). Fiscal policy directly affects the aggregate demand of an economy. Recall that aggregate demand is the total number of final goods and services in an economy, which include consumption, investment, government spending, and net exports. fiscal policy is a type of economical intervention where the government injects its policies into an economy in order to either expand the economyis growth or to contract it. By changing the levels of spending and taxation, a government can directly or indirectly affect the aggregate demand, which is the total amount of goods and services in an economy.One thing to remember concerning fiscal policy is that a recession is generally defined as a time period of at least two quarters of consecutive reduction in growth. It may take time to even recognize whether or not there is a recession. With fiscal policy, there will be certain levels of lag time in which conditions will deteriorate before being recognized. At the same time, fiscal policy takes time to implement due to legislative and administrative processes, and those same policies will take time to show results after implementation.Consumers can also react to these policies positively or negatively. Most consumers would have a positive reaction per say to a policy that lowers taxes, while some will have an issue with a government spending more which will increase the burden of debt on nations citizens.Nevertheless, fiscal policy is a type of intervention that can help to control the direction of an economy. Deciding if and when it should be used will certainly continue to be debated.

An economy is in short-run equilibrium when the aggregate amount of output demanded is equal to the aggregate amount of output supplied. In the AD-AS model, you can find the short-run equilibrium by finding the point where AD intersects SRAS. The equilibrium consists of the equilibrium price level and the equilibrium output.an economy in disequilibrium results in price adjusting until the market finds an equilibrium. The same general idea applies to a short-run macroeconomic equilibrium as well, but with a minor modification. If the amount of output demanded is greater than the amount of output produced, people chase after the limited goods available and drive up the price level. In response to the increase in the price level, producers create more goods and services. This continues until the amount of aggregate production equals the amount of aggregate demand.

One of the goals of macroeconomics is to explain why business cycles occur. We can use the AD-AS model to capture the different stages of the business cycle. The AD-AS model helps compare our current output (the short-run equilibrium) to the full employment output. The difference between current output and the full employment output is called a “gap”.Negative output gaps mean that an economy is producing less than full employment, while positive output gaps mean that an economy is producing more than full employment output. Positive output gaps are sometimes called “inflationary gaps” because producing more than full employment is usually associated with a higher price level.

Government spending includes the purchase of goods and services - for example, a fleet of new cars for government employees or missiles for national defense. Government spending is a fiscal policy tool because it has the power to raise or lower real GDP. By adjusting government spending, the government can influence economic output.In addition to the primary effect of government spending on the economy, this spending multiplies through the economy as it affects businesses who sell the goods and services bought by the government. Consumers then go on to spend the paychecks they earn from those businesses, stimulating real GDP even more.Taxes are a fiscal policy tool because changes in taxes affect the average consumer's income, and changes in consumption lead to changes in real GDP. So, by adjusting taxes, the government can influence economic output. Taxes can be changed in several ways. Firstly, marginal tax rates can be raised or lowered. Secondly, they can be eliminated entirely, or the tax rules can be modified.

Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groupsa tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are “revenue neutral” may be construed as fiscal policy—and may affect the aggregate level of output by changing the incentives that firms or individuals face—the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them.

Difference between monetary and fiscal policy.

Monetary policy

• Monetary policy involves changing the interest rate and influencing the money supply.
• it set by a Central bank
• monetary policy target inflation
• its side effect on exchange rate and housing market
• mostly independent from the political process

fiscal policy

• Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.
• It set by the Government
• fiscal policy has no specific target
• Side effect on government budget .
• Strong political dimension to changing tax rates

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy that shifts the aggregate demand curve to the right.The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy that shifts aggregate demand to the left.The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment.