Question

The economy is going through a boom period with low unemployment and high inflation.

1. Draw a graph of aggregate demand and aggregate supply to illustrate the current situation.
2. Discuss fiscal policy measures that would help restore the economy to its natural rate of output.
3. What kind of monetary policy will the central bank implement to reduce inflation? Describe the tools of monetary policy that can be used.
4. Draw a graph to show the effect of the fiscal and monetary policies on output and the price level.

Answer 1

As shown in graph 1

Point A shows a boom phase

Where Y1 > Y0 i.e. Output is higher than potential

Also, P1 > P0 i.e. Price levels are high as well (inflation)

Contractionary fiscal policy is good to bring back economy to normal. Tools used can be G and T (G-Government spending, T-Taxes). In contractionary policy G decreases or T increases. This will shift AD left and will reduce Output.

Contractionary fiscal policy will help bring inflation back to normal. Tools used can be

1.reserve requirement

2. policy rate

3. open market operation

For contractionary policy central bank may increase reserve requirement, may increase policy rate or may buy bonds in open market operations. All of this will reduce liquidity and inflation.

Graph 2 represents economy coming back to Normal O, after implementation of contractionary fiscal and monetary policies.