Question

1. To fight a inflation

a) How should the government execute Fiscal Policy?

b) How should the Federal Reserve Bank execute Monetary Policy?

Make sure to include the appropriate graphs and analysis and how these policies each affect C,I, G, NX, AD, AS, P, Q, inflation, and economic growth.

Answer 1

To fight inflation, government and federal reserve can opt for contractionary fiscal policy and contractionary monetary policy respectively.

(a) Supoose government increases income tax rate. Increase in the tax rate would lower disposable income of people resulting in lower demand for goods and services. Thus consumption falls. Fall in the dispossble income also lower imports. IS curve shifts to left which leads to fall in the level of output/income and interest rate. Lower interest rate makes cost of borrowing cheaper resulting in increase in investment. Leving income tax rate generates revenue for the government thus spending by government increases. Lower interest rate stimulates the foreign exchange market by huge capital inflows thus appreciating the domestic currency. This causes fall in the export. Overall aggregate demand in the economy falls resulting in lower prices lower supply of goods. This will ease the inflation rate of the economy.

b) Suppose federal reserve decreases money supply in the economy by selling government bonds. This results in increase in interest rate and lower output. Rise in interest rate leads to less demand for money because the cost of holding money will increase resulting in lower spending on goods. Thus both consumption and demand for foreign goods(imports) fall. High interest rate discourages investment and leads to huge capital outflows resulting in the depreciation of domestic currency. This will boost exports. Overall aggregate demand for goods and services fall. This leads to lower price level resulting in lower supply of goods.