Question

In 2008, the United States is in a recession. The following measures are implemented:

a. The FED increases the quantity of money. Illustrate with an AD/AS graph the effect of this measure on the economy. Indicate the change in real GDP, the price level and unemployment rate.

b. In addition to the increase in money, the federal government cuts taxes. Illustrate the effect of these measures on the economy. Indicate the change in real GDP, the price level and unemployment rate.

Answer 1

a. Recession means short run equilibrium, point E is before full employment level output and there is an inflationary gap. Fed responds to this by decreasing discount rate to make lending easy and money supply increases. Thus, aggregate demand increases and AD curve shifts to right. AD" intersect SRAS and LRAS at E'' and both output and price increases. On Phillips curve, it shows that increase in price level led to decline in unemployment.

b. Tax cut also increases aggregate demand. Tax cut is part of the fiscal policy and this leads to increase in disposable income and hence aggregate demand increases and AD curve shifts to right. AD" intersect SRAS and LRAS at E'' and both output and price increases. On Phillips curve, it shows that increase in price level led to decline in unemployment.