Question

1) If an economy is experiencing an inflationary gap, will the Federal Reserve System seek to lower or raise interest rates? How will it do that?

2) What is meant by the term "automatic stabilizer"? What are some examples of automatic stabilizers? How do automatic stabilizers differ from discretionary fiscal policy?

Answer 1

1) federal reserve system would be willing to increase the rate of interest in order to close the inflationary gap because the current GDP is greater than full employment GDP and increasing the rate of interest will discourage investment. This will be reducing aggregate spending and hence aggregate demand curve will be shifted to the left bringing the real GDP back towards full employment level. this can be done by decreasing the money supply using open market sales of government securities.

2) automatic stabilizer instruments that automatically pacify the the economy when it is expanding and stimulate the economy under a recessionary phase. Automatic stabilizers stabilize the level of output and the include taxes transfers and other welfare payments. these are different from discretionary fiscal policy because discretionary fiscal policy requires government policy proposal, passing of a legislation in parliament, and implementing the policy explicitly. Automatic stabilizers do not require government specific action and they work on their own as and when current GDP changes.