Question

Question 4: Freefall

Belugaland is a small economy whose primary product is caviar: which is the French word for “smelly fish eggs”.

Unfortunately for Belugaland, meteorologists identify an adverse weather pattern named “El Noono, the midnight

sun” that may hit the country in the future. When it comes, El Noono will heat up the ocean and kill all the smelly

fish that lay the smelly eggs thus inevitably destroying the income of the Belugans. Faced with the possibility of

a fall in future income the Belugan people lose confidence in the future and cut back on their consumption of all

goods. Furthermore, investors become wary of starting factories that can produce fish-eggs resulting in a fall in

investment as well. Assume that the economy is currently at Y* and answer the following questions. [When you

answer these questions, you can ignore the actual impact of El Noono when it hits the economy in the future,]

a) Use an AD/IA diagram show what happens in the short run and in the long run when the Belugans cut back

on their consumption and investment spending.

b) The leader of Beluga, King Salamander, who used to be an accountant, raises taxes to make sure the gov-

ernment budget is balanced. Using the AD/IA diagram you drew in a) show the long-term impact of an increase in

taxes on Belugaland’s already battered economy.

c) If you were King Salamander’s trusted financial advisor what fiscal policy/policies would you recommend

instead of increasing taxes? Graphically describe how this would help increase output in Belugaland.

d) If you were King Salamander’s top central banker, what monetary policy would you pursue (ignoring the

possibility of a fiscal policy response)? Graphically describe how this would help increase output in Beluga.

Answer 1

(b.)