Question

1. Suppose that the economy is suffering from high levels of unemployment. What kind of fiscal policy should be adopted and what are the options for implementing that policy? Briefly explain and use a Aggregate Demand (AD) and Aggregate Supply (AS) graph to illustrate the policy.

2. Now suppose the economy is suffering from high rates of inflation. What kind of fiscal policy should be adopted and what are the options for implementing that policy? Briefly explain and use a Aggregate Demand (AD) and Aggregate Supply (AS) graph to illustrate the policy.

3. What if the government incurred a deficit in trying to address the problems of a business cycle recession or trough. What is the argument against deficit spending known as “crowding out”? In your own words and a graph explain what crowding out is.

Answer 1

Answer 1.

When the economy is suffering from high levels of unemployment, it also implies that the economy is in recession. During recession, the government pursues "Expansionary Fiscal Policy."

To elaborate on the expansionary fiscal policy, the government can cut tax rates when unemployment is high. This results in an increase in disposable income for consumers. As the disposable income increases, consumption spending increases in the economy and higher consumption spending also encourages higher investment spending. Relative increase in investment spending creates jobs, which triggers further growth in consumption spending. The result is that the aggregate demand curve shifts to the right and the recessionary gap is closed.

Similarly, the government can increase government spending on social security, infrastructure, education and the defense sector. When government spending increases, it creates jobs in these sectors and any associated sector. This triggers higher consumption spending in the economy. At the same time, higher social security spending and extension of unemployment benefit ensures that consumption spending remains healthy for the low-income household and the unemployed.

Specific to the United States, higher consumption spending is critical because 70% of US economic growth is driven by consumption.

The chart below gives the long-run aggregate supply (LRAS) and short-run aggregate supply (SRAS) curve that remain unchanged while expansionary fiscal policy is pursued. When the economy is in recession, the aggregate demand curve is represented by AD1 with output at Y and price level at P. With the expansionary fiscal policies discussed, the aggregate demand curve shifts to the right from AD1 to AD. This represents the point where actual output is equal to the potential output. The output increases to Y1 and the price level increases to P1.

Answer 2.

When the economy has high inflation, it implies that economic growth is robust and the actual output is higher than the potential output. In other words, the economy is in an "inflationary gap." To resolve this situation of high inflation, the government pursues contractionary fiscal policy.

This involves an increase in tax rate. When tax rate trends higher, consumer disposable income declines and this translates into relatively lower consumption spending. At the same time, investment spending is impacted in a relative basis. The government can also reduce government spending and this implies lower demand for goods and services from certain sectors of the economy. Just as an example, the defense spending reduction and impact the defense and associated sector. Overall, there is lower consumption and investment spending in the economy and the aggregate demand curve shifts to the left.

The chart below gives the long-run aggregate supply (LRAS) and short-run aggregate supply (SRAS) curve that remain unchanged while contractionary fiscal policy is pursued. When the economy is in a phase of boom, the aggregate demand curve is represented by AD1 with output at Y1 and price level at P1. With the contractionary fiscal policies discussed, the aggregate demand curve shifts to the left from AD1 to AD. This represents the point where actual output is equal to the potential output. The output declines to Y and the price level decreases to P. Therefore, inflation is curbed with relatively lower level of output.

Answer 3.

When government spending increases, the government generally has budget deficits. In other words, the expenses are more than the revenue. The government needs to cover this budget deficit through borrowing funds. When government borrowing increases, the supply of loanable funds for the private sector decline. As the supply curve for loanable funds shifts to the left, the interest rates trend higher on relatively lower supply of funds (liquidity) for loans.

At higher interest rates in the economy, the private sector is less willing to pursue investment spending. Because interest rates represent cost of money and higher cost of money is not favorable for the private sector.

Therefore, this decline in investments from the private sector due to higher interest rates (as a result of government borrowing) is known as "Crowding Out."