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Suppose that government enacts a major tax increase. At the same time, the Federal Reserve uses...

Suppose that government enacts a major tax increase. At the same time, the Federal Reserve uses monetary policy in such a way that the combined effect of the tax increase and the monetary policy is that GDP DOES NOT CHANGE at all. Based on this information, explain clearly what the overall (short-run) effect of the two policies must have been on (A) Investment (B) The price level. (Assume prices are flexible or can change.) (C) The government budget balance (please be sure to explain clearly in words how each variable is
affected).

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Answer #1

Since GDP does not change, it means that FEd undertook expansionary monetar policy to counteract the contractionary fiscal policy.

A) Investment - Expansionary monetary policy means fal in interest rate. So investment would rise.
B) The net effect would be that AD curve would not have changed (since output is constant) so price level remains the same.

C_ Government would get surplus as government spending is same but tax revenue rose.


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