Question

As you answer these questions, be sure that you EXPLAIN YOUR ANSWERS IN DETAIL AND SHOW YOUR CALCULATIONS. Remember you are showing off how much you know about economics and one or two sentences shows me you don’t know very much.

Question One: Fiscal Policy Assume the United States economy has the following:

• GDP is $18,500 billion down from $19,350 billion nine months ago.

• Unemployment is at 6.8% up from 4.2% nine months ago.

• Inflation is stable at 2.0%. • MPC=.75 • NRU=4.0%

• Target Inflation is 2.0%

1. Explain in detail the problem the country is facing. Include an analysis of both inflation and unemployment including whether the economy is in a recession or not.

2. What is the size of the GDP gap? Show the calculations.

3. Government could address the problem with either increasing government spending, cutting taxes or both. If the government decided to increase spending to address the problem, by how much should spending be increased? If the government decided to cut taxes to address the problem, by how much should taxes be cut? Show the calculations and provide explanations.

4. Should the government cut taxes or increase spending or some combination of both to address the problem? Detailed Explanations!!

5. What could happen to make the policy you recommended in Question 4 ineffective? On this question, be sure to read the section in your text beginning on page 275. Don’t just make something up. It will take a paragraph or two to answer this question because you need to relate the specific complication to the scenario described in the question.

Question Two: Monetary Policy Assume the United States economy has the following:

• GDP is $15,600 billion up from $13,400 billion four years ago.

• Unemployment is at 4.0% down from 7.7% three years ago.

• Inflation is at 3.7% up from 1.2% four years ago.

• NRU = 4.0%

• Target Inflation is 2.0%

1. Explain in detail the problem the country is facing.

2. Should the Federal Reserve adopt an easy money or tight money policy? Explain!

3. Which policy tool should the Federal Reserve use to carry out the policy you recommended in Question 2? Detailed explanation as to why the choice is correct and how the tool works to address the problem.

4. What could happen to make the policy you recommended in Question 2 ineffective? On this question, be sure to read the section in your text beginning on page 343. Don’t just make something up. It will take a paragraph or two to answer this question because you need to relate the specific complication to the scenario described in the question.

Answer 1

Answer 1:

The country is facing the problem of recession because GDP in the economy is below the full employment GDP in the economy and thus there recession in the economy. The unemployment level in the economy is also above the natural rate and inflation rate is also low. Thus, overall aggregate demand in the economy is low which has led to recession in the economy.

Answer 2:

The size of GDP gap = Potential GDP - Actual GDP = $19,350 - $18,500 = $850 billion.

Answer 3:

Change in output = Multiplier * Change in Government Spending.

Thus, change in government spending = Change in output * (1-MPC) = 850 * 0.25 = $212.5 billion.

For change in taxes , Change in output = MPC / 1- MPC * Change in taxes ,

Thus, change in tax rate = Change in output * 1-MPC / MPC = 850 * 0.25 / 0.75 = $283.33 billion.

Thus, to eliminate the recessionary gap, government spending should be increased by $212.5 billion and taxes should be reduced by $283.33 billion.

Answer 4:

To address the problem government should increase expenditure because this will increase government deficit by a smaller amount as compared to reduction in tax rate. This is because government spending as a direct impact on aggregate demand whereas tax rate impact disposable income which in turn impact consumption expenditure and this impacts aggregate demand in the economy.