Question

Question :

Consider the following:

A number of countries, like Greece and the United Kingdom, have in the past few years responded to growing and problematic levels of debt by introducing “austerity” policies: significant cuts to government purchases (G) combined with significant tax (T) increases. These policies have been controversial among both economists and the public.

(a) Using the AS/AD model, what is the short-run effect of the austerity policy on prices and output?

(b) What is the short-run effect of the austerity policy on the unemployment rate? (c) Using the AS/AD, what is the long-run effect of austerity on prices and output? (d) What is the long run effect of austerity on the unemployment rate?

c. explain the type of issues of this policy.

Question 2:

An economy is facing a recessionary Gap.

a. Draw AS and AD in the SR to show the Gap.

b. Suggest a Monetary policy and illustrate the changes in the bonds Market, Money market and exchange rate

c. Explain the effects on C, I, X.

Answer 1

Answer 1.

(a) Due to the austerity policy, government spending decreases and tax increases, due yo this the IS curve shifts to the left, likewise, the AD curve also shifts to the left(From AD to AD'), resulting in the decrease in prices as well as output. In the short-run, the austerity policy results in a decrease in prices as well as output, because of the contraction of the AD curve. (refer to diagram 1)

(b) In short-run, the austerity policy/fiscal contraction will result in increasing the unemployment rate, because as the output produced now is below the equilibrium level, hence, there will be less requirement of employees to produce less quantity compared to before.

(c) Initially, the economy is in a long equilibrium, where it is at full employment output level (vertical supply curve), As the economy faces negative AD shock, it would be in the contractionary phase of the business cycle and have a negative output gap. This decrease in AD will cause a decrease in the price level. In the long run, a decrease in the price level will result in a decrease in input prices as well as the expectations about inflation, which will result in the increase in Short-run AS to shift to the right. therefore, in the long run, when the price level has decreased, but the new output will be equal to the full-employment output. (refer to diagram 2)

(d) In the long run, the austerity policy doesn't result in a decrease in the unemployment rate, but the wage rate falls.

(e) A contractionary fiscal policy makes the economy, less lucrative as it decreases the purchasing power of the citizens, they are able to gain less utility. though ut keeps the inflation in check, at the cost of the increased unemployment rate and lesser wages.

Question 2:

(a) A recession occurs when demand is less than supply. (refer to diagram 3).

(b) To get out of recession, Monetary expansion policies must be used which leads to a rightward shift in the LM curve, due to which rate of interest falls, the short-run AS curve shifts to the right,  output increases, and the exchange rate appreciates.

(c) In the recession, consumption falls, the interest rate also falls, the exchange rate depreciates.