Question

Explain how will each of these affect the economy in the short run and the long run (in terms of output, unemployment and inflation) 3. For each of the following what kind of monetary policy do you suggest?

a. Government decides to take policy to reduce deficit.

b. Construction workers goes on a strike for 2 months.

c. US dollar depreciates with respect to euro

d. People become more optimistic about the economy

e. Productivity of U. S workers increase due to technological advancement

Answer 1

a) Government decides to reduce deficit , contractionary fiscal policy by increasing taxes and reducing spending . So consumption will fall in short run . Total income will fall in the economy . Prices will come down since aggregate demand will fall . There will be recessionary trends in long run . Unemployment will rise . In such a case expansionary monetary policy should be adopted to steer the economy out of recession .

b) If construction workers go on a strike that will reduce production , supply will fall in short run . Output falls . But in the long run , this will result in higher price of goods or inflation , rise of employment will occur . In long run there will be potential output but inflation will be present . So tight money policy should be followed to reduce inflation .

c) When US dollar depreciates then imports become more expensive and exports become very cheap . In the long run this leads to a smaller trade deficit . AD shifts right . Price level rises . Employment rises . Total income rises . Contractionary monetary policy in this case checks inflation ,

d) People becoming more optimistic about the economy is a positive demand shock . Autonomous consumption increases , hence AD shifts right . Output and inflation increase in the short run; in the long run, output falls back to potential, and inflation increases . Contractionary monetary polic should be followed in long run .