Question

Assume a closed economy. Suppose you have the following information regarding Country A: Long run real GDP growth rate = 2.5%, natural rate of unemployment = 5%, long run inflation rate = 2.5%. Currently, real GDP is growing at 1.4%, unemployment is at 6.4%, and inflation is .7%.

a. Using the IS-LM model and AD-AS, describe fully the current state of the economy both graphically and in words.

b. What monetary policy measures would you advocate? Why? How would they work and what would they do in the short run? In the long run?

c. What fiscal policy measures would you advocate? Why? How would they work and what would they do in the short run? In the long run?

Answer 1

(a) Lower real GDP growth rate, higher unemployment and lower inflation compared to the full-employment level indicates a recession where aggregate demand is low.

In following IS-LM graph, IS0 and LM0 are full-employment IS and LM curves intersecting at point A with interest rate r0 and real GDP (= potential GDP/output) Y0. Due to recession, position of IS curve is at IS1 (to the left of IS0), intersecting LM0 at point B with lower interest rate r1 and lower real GDP (output) Y1.

In following AD-AS graph, long run equilibrium is at point A where aggregate demand (AD0), short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0) intersect with initial price level P0 and real GDP (potential GDP) Y0. Due to recession, position of AD curve is at AD1 (to the left of AD0), intersecting SRAS0 at point B with lower price level P1 and lower real GDP (output) Y1, creating a recessionary gap of (Y0 - Y1).

(b) An expansionary monetary policy measure should be adopted to increase money supply, lowering interest rate that will boost investment demand, raising aggregate demand and restoring real GDP to full-employment level, eliminating the short run recessionary gap, increasing price level. In long run, higher price level will increase cost of inputs, so firms will lower output, decreasing aggregate supply and increasing price level further. An expansionary monetary policy can be implemented by central bank's open market purchase of government securities and/or by lowering required reserves ratio and/or by lowering discount rate.

(c) An expansionary fiscal policy measure should be adopted to increase government spending that directly increases aggregate demand, and/or lowering taxes that will boost consumption demand, raising aggregate demand and restoring real GDP to full-employment level, eliminating the short run recessionary gap, increasing price level. In long run, higher price level will increase cost of inputs, so firms will lower output, decreasing aggregate supply and increasing price level further.