Question

Explain what happens to the output gap, unemployment, and inflation in the short run if there is a permanent income tax cut implemented by the federal government. You do not need to draw any graphs, but thinking about the short run model will help. Be sure to explain which part of IS/MP/PC is affected and why. You may start with an economy at full employment and inflation at the central bank target. Also, discuss what the central bank is likely to do in response to this event.  

The MP curve in the short run model assumes that monetary policy heavily influences the real interest rate in all credit markets. This is a bit of an oversimplification and there are a number of steps that must occur for this link to remain strong.  

What tool does the U.S. Federal Reserve use to conduct policy? Explain the chain of events from policy to credit markets.

Next, once real interest rates have responded to the monetary policy, explain how this will cause a change in the output gap.

Answer 1

The effect of excessively high demand is the businesses and employees must work beyond their maximum efficiency level to meet the level of demand. A positive output commonly spurs inflation in an economy because both labor costs and the prices of goods increase in response to the increased demand.

The inflation gap, in economics, is the amount by which the actual gross domestic product exceeds potential full-employment GDP. The main cause of the gap is considered to be expansionary monetary policies carried out by the government.

The relationship between the inflation rate and unemployment rates is inverse. Graphically, this means the short run, the Philips curve is L-shaped. Phillip's curve shows the relationship between inflation and unemployment. In the short run, inflation and unemployment are inversely related as one quality increases, the other decreases. In the long run there is no trade off.

A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy.

Philips curve argues that unemployment and inflation are inversely related

As the level of unemployment decreases and inflation increases.

It is not Linear

Theoretical Phillips curve

The Philip curves show the inverse trade-off between the rate of inflation and the rate of unemployment. If unemployment is high, inflation and rate of unemployment low, inflation will be high.

Philips curve and aggregate demand share similar components. The Philip curve is the relationship between in effect the price level aspect of aggregate demand  

In the 1970s economists believed that the short-run Philips was stable. By the 1970's economics events dashed the idea of a predicated philips curve.

FEDERAL RESERVATION THREE INSTRUMENT OF MONETARY POLIVY

Open market operation

Discount rate

Reservation requirement

Monetary policy impact the money supply in an economy, which influences interest rates and the inflation rate. It also impact business expansion, net exports, employment, the cost of consumption versus saving all of which directly or indirectly impact aggregate demand.