Question

Suppose the government misjudged the natural rate of unemployment to be much lower than it actually is, and thus, undertake expansionary fiscal and monetary policies to try to achieve the lower rate. Explain why these policies might at first succeed and the outcome in the long run. [HINT: SR Philip Curve, and LR Philip Curve]. b). Discuss briefly, the mechanism by which monetary policy affects GDP and the price level in an economy. c). Explain the relationship between tax rates, tax rvenues, and aggregate supply.

Answer 1

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Question:

Answer:

Introduction:

Natural rate of unemployment:

This is a type of unemployment that is only found in a healthy economy. Here there is no cyclical unemployment, only structural and frictional unemployment are found. There is no zero unemployment found in any economy. Natural unemployment is the minimum level of unemployment and a healthy sign for a economy also.

Monetary Policy:

Monetary policy is a policy adopted by the central bank globally to control the money supply in the economy. Money supply direct affect to the interest rate and inflation and employment level. When the central bank increases the money supply (its also called expansionary monetary policy), it decrease the interest rate. Decreasing of lower interest rate increase the demand of money in the economy that increase the consumption and investment level that increased AD. Increased AD increased GDP and price level. When investment increase and GDP increase then increase production level that increase the employment level and income level that further positively affect the AD again and its a healthy sign for a economy. There are many tools that is taken in used the central bank to control the money supply like, discount rate, buying or selling of the government securities, reserve requirement etc. When the central bank follow the expansionary monetary policy then it either reduce discount rate or buying the government securities or reducing the reserve requirement.

Fiscal Policy:

Fiscal policy is a policy that is adopted by the government that is related with the government spending and revenue. When a government follow a expansionary fiscal policy the government decreases the tax rate and increases spending. Increase spending and reducing tax rate boost the income level that boost investment and consumption that increased the AD and increasing AD increased GDP and price level. Its increase production level that increase the employment level and income level that further positively affect the AD again and its a healthy sign for a economy.

Philips Curve:

It is a macroeconomic concept that says that when inflation level increase, unemployment level decrease and vice-versa. It means inflation and unemployment have opposite relation and and move together in opposite direction:

In the short the increasing AD increased the GDP and price level but in the long run there is no trade-off as Long Run AS is inelastic. So, in long-run because in long run economy work at full capacity and there is not further scope to increase further. In long run the unemployment is very low with higher inflation rate rate motivate to the employees to demand for higher wages to manage the gap between real and nominal wages. Other side lower unemployment, high income level boost the AD but in long run long Run AS is inelastic so producers increase the price level. So, its causes increasing unemployment and higher inflation that can push to the economy in stagflation phase that becomes a serious problem for the economy in long-run.

Now come on the question:

a). Answer:

As per the question,  the government misjudged the natural rate of unemployment to be much lower than it actually is, and thus, undertake expansionary fiscal and monetary policies to try to achieve the lower rate. We have seen above about the expansionary monetary and fiscal policy and how does it affect the economy. A expansionary fiscal and monetary policy increase the GDP, inflation, employment level and production. In the short the increasing AD increased the GDP and price level but in the long run there is no trade-off as Long Run AS is inelastic. So, in long-run because in long run economy work at full capacity and there is not further scope to increase further. In long run the unemployment is very low with higher inflation rate rate motivate to the employees to demand for higher wages to manage the gap between real and nominal wages. Other side lower unemployment, high income level boost the AD but in long run long Run AS is inelastic so producers increase the price level. So, its causes increasing unemployment and higher inflation that can push to the economy in stagflation phase that becomes a serious problem for the economy in long-run.

b). Answer:

Monetary policy is a policy adopted by the central bank globally to control the money supply in the economy. Money supply direct affect to the interest rate and inflation and employment level. When the central bank increases the money supply (its also called expansionary monetary policy), it decrease the interest rate. Decreasing of lower interest rate increase the demand of money in the economy that increase the consumption and investment level that increased AD. Increased AD increased GDP and price level. When investment increase and GDP increase then increase production level that increase the employment level and income level that further positively affect the AD again and its a healthy sign for a economy. There are many tools that is taken in used the central bank to control the money supply like, discount rate, buying or selling of the government securities, reserve requirement etc. When the central bank follow the expansionary monetary policy then it either reduce discount rate or buying the government securities or reducing the reserve requirement.

Fiscal policy is a policy that is adopted by the government that is related with the government spending and revenue. When a government follow a expansionary fiscal policy the government decreases the tax rate and increases spending. Increase spending and reducing tax rate boost the income level that boost investment and consumption that increased the AD and increasing AD increased GDP and price level. Its increase production level that increase the employment level and income level that further positively affect the AD again and its a healthy sign for a economy.

C). Answer:

Relationship between tax rates, tax revenues, and aggregate supply.

Tax is the main source of income for a government. When government want to increase their tax revenue then its increase the tax rate and vice-versa. When government expenditure is less than income/revenue then its called budget deficit and when government expenditure is more than income/revenue then its called budget surplus. During a expansionary  fiscal policy the government decreases the tax rate and increases spending. Increase spending and reducing tax rate boost the income level that boost investment and consumption that increased the AD and increasing AD increased GDP and price level. Its increase production level that increase the employment level and income level that further positively affect the AD again and its a healthy sign for a economy. When government decreases the tax rate then its increase the disposable income of the individuals tax payer and reducing corporate tax increase the net profit of the corporate houses. So, increasing disposable income increase the consumption and increasing net profit increases the investment level in the economy that increase the AD and production and productivity that increase AS also. So, increasing AD and AS increase GDP, price level, employment level and income level together. When tax rate increase its increase the tax revenue and vice-versa.

Increasing tax from a appropriate level can harm the production level and decrease the AS. There is no scope for increasing the tax rate but during the boom time government can increase the tax revenue through increasing tax rate. During the recession phase government take loan or borrow to fulfill the gap between total revenue and total spending. Increasing tax also harm the disposable income of the individual tax payers and reduced their disposable income that decreased the AD that negatively affect the economy. Increasing AD regularly for a long time decrease the growth rate and inflation that creat a uncertainty for the future growth into the mind of investors and consumers that harm. Decreasing inflation increased unemployment level and decreasing GDP or AD also reduce the production that negatively affect the AS. Decreasind AS further boost the high unemployment level

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