Question

Suppose the economy is currently in short run macroeconomic equilibrium, with actual GDP smaller than potential GDP.

(a) Depict this situation using AD-AS, being sure to label all curves and axes.

(b) Give an example of an automatic stabilizer, and explain how it could close the gap this economy has.

(c) What open market operation could the Federal Reserve carry out, to close this gap? Show graphically the effect it would have.

Answer 1

a) The short run equilibrium is a point where AD intersect SRAS which yields Y1 as the current output and Yf as the full employment output..P1 is the price level.Since actual GDP ie Y1 is less than Potential GDP ie Yf , the economy is experiencing recession ie negative output gap..

b)The economy needs to increase output to close recessionary gap by using expansionary fiscal policy.Expansionary fiscal policy tools may be increasing government spending,decreasing taxes , increasing government transfers.These tools will increase aggregate demand and increases output and employment.

c)When the economy is in recessionary gap the Fed can use expansionary monetary policy to close the gap.The Fed will increase money supply in the economy by buying or selling securities and bonds ie using open market operations, lowering the reserve rate or decreasing the discount rate.When the Fed purchases a security from the public , the reserves with the bank will rise thus increasing the money supply.

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