Question

For a hypothetical country, assume the current unemployment rate is 3.8% and the NRU is 4.5%. Actual GDP is $612 billion but Potential (full-employment) GDP is $600 billion. Assume prices are flexible upward but inflexible downward. It has been noted that there is a $7.50 change in consumption spending for every $10 change in income (real GDP).

a. In what phase of the business cycle is this economy? Explain. What do you expect is occurring with the rate of inflation?

b. What specific (increase or decrease; $ amount) discretionary fiscal policy changes could Congress pass to achieve full employment GDP?

i. G:

ii. T:

iii. Combination

c. Under the original conditions, in what way would the built-in stabilizers (automatic fiscal policy) change the federal budget (toward deficit or surplus)?

d. What specific monetary policy changes might the Fed consider in order to stabilize the economy:

i. Open Market Transactions: Buy or Sell? As a result, what happens to the Fed Funds rate?

ii. Reserve Requirement: Increase or Decrease? How likely is the Fed to change this? Why?

iii. Discount Rate: Increase or Decrease?

iv. Interest on Bank Reserves Deposited at the Fed: Increase or Decrease?

e. Briefly describe how the open market transactions you chose (buy or sell) would work to affect the economy.

Answer 1

1) It is in Expansion phase ,where there is inflationary inflation rate is rising.

2)GDPgap=12

Goverment spending multiplier=1/0.25=4

Required Decrease in government spending=12/4=3

Taxmultiplier=0.75/0.25=3

Required tax increase=12/3=4

Combination=12 Decrease in government spending and 12 Increase in taxes.

C)It will lead to budget surplus as goverment revenue ( tax) are increasing while spending ( G) is decreasing.

D)Fed will sell bonds . Which Decrease Money supply and increase federal fund rate.

ii) Increase reserve requirement ratio.

iii) discount rate increase to increase the cost of giving loans and thus Increase cost of borrowing by Investor from banks.

iv) Increase,which lead to banks to make more reserve and deposit it at fed . Which Decrease banks loans and thua reduce money supply.

E) Selling bonds to public and banks will decrease monetry base as curreny from banks and loanable funds of banis Decrease.

As a result of these two changes , Monetry base Decreases and thus lead Decrease in money supply. Decrease in money supply, Increase interest and thua Increase in cost of investment and Investment Decrease and thus lead decline in AD and GDP.