Question

For each of the event below, show the short-run effects on output, price and unemployment and explain how the Fed should adjust the money supply and interest rates to stabilize output

A. President Bush’s tax cut the individual income tax by $2000 per household in 2003.

B. Federal government issues the treasury bonds to finance the war in Iraq, and sell them to U.S citizens.

C. Illinois state government increases income tax for the residents in Illinois to pay for education and pension deficits.

Answer 1

A.

Tax cut:

Once there is tax cut, the disposable income of consumers would increase. Disposable income is the excess of income over tax. It increases money flow in the economy and purchasing power of consumers.

Output: Since there is increasing money flow, there would be increasing production and increasing output in the short-run.

Price: Since there is increasing purchasing power of consumers, the available products in the market would be demanded more. This thing pushes the price level and it will be increasing, better known as inflation.

Unemployment: It reduces unemployment, since the increasing money supply increases job opportunity and employment.

Adjustment: If the inflation is too high, the Fed should increase the rate of interest so that the interest burden of borrowers increases; it decreases purchasing power and demand of goods, because money supply in the economy decreases. Therefore, by increasing interest rates the Fed can adjust the money supply by decreasing it.

B.

Issuing treasury bonds:

This is the way of decreasing money supply, because by selling the Fed is actually taking out money from the economy.

Output: Since there is decreasing money flow, there would be decreasing production and decreasing output in the short-run.

Price: Since there is decreasing purchasing power of consumers because of non-availability of money, the available products in the market would be demanded less. This thing reduces the price level, better known as deflation.

Unemployment: It increases unemployment, since the decreasing money supply decreases job opportunity and employment.

Adjustment: The Fed should decrease the rate of interest so that the interest burden of borrowers decreases; it increases purchasing power and investments, because money supply in the economy increases. Therefore, by decreasing interest rates the Fed can adjust the money supply by increasing it.

C.

Increasing tax by a state government:

It decreases money supply, since the increasing tax decreases the disposable income of consumers.

Output: Since there is decreasing money flow, there would be decreasing production and decreasing output in the short-run.

Price: Since there is decreasing purchasing power of consumers because of non-availability of money, the available products in the market would be demanded less. This thing reduces the price level, better known as deflation.

Unemployment: It increases unemployment, since the decreasing money supply decreases job opportunity and employment.

Adjustment: The Fed should decrease the rate of interest so that the interest burden of borrowers decreases; it increases purchasing power and investments, because money supply in the economy increases. Therefore, by decreasing interest rates the Fed can adjust the money supply by increasing it.