Question

The United States is suffering from a high rate of unemployment.

1. Identify two fiscal policy actions that Congress might initiate to solve the problem.
2. Using a correctly labeled AD/AS graph, show and explain how the policies you identified in (a) will affect each of the following in the short-run.
   1. aggregate demand
   2. output and employment
   3. price level
3. Explain how the policies you identified in part (a) will impact real interest rates in the short-run.
4. If the interest rate effect you identified in part (b) continues in the long run, explain how economic growth will be impacted.

Answer 1

a) US government can think of expansionary fiscal policy(Increase in government spending, reduction in tax rate, direct Transfer payments in the form of unemployed benefits) to reduce the problem of unemployment.

b) 1.Because of expansionary fiscal policy, AD curve shifts right from AD to AD' as shown in the picture above.

b) 2. As we can see in the above picture, As AD curve shifts rightwards both prices and output increases. The hike in price gives incentive to producers to produce more resulting in more employment. Thus both output and employment increses.

b) 3. Decrease in tax rate, increased the disposable income thus raise the demand for goods. Further Unemployment benefits to unemployed also raise the demand for goods.As a result Price level rises in the short run.

C) Expansionary fiscal policy is always accompanied by increase in the rate of interest. In the short run, with a constant inflation, real interest rate increases. (Real interest rate=Nominal interest rate- inflation rate) .

d) Increase in the real interest rate in the long run will have a crowding effect on the economy. Increase in government expenditure would raise interest rate and output and thereby employment. Higher real interest rate makes investment costlier thus investment will decline. Thus this will crowd out partially or fully the increase in output(employment) by increase in government spending.