Question

Now, assume that a financial crisis has been continuing for 10 years in the USA. We call this period as a long run period.

To answer the following questions, you should use a sum of relevant economic theories (if require) for the justification of their answers.and can also use figures (i.e., supply and demand curves) for presenting their answers.

Assume that you are a policy maker in USA’s government and central bank; how you can recover the crisis by changing macroeconomic variables?
During the crisis, How USA can recover its output gap if it faces an expansionary gap?
During the crisis, How USA can recover its output gap if it faces a contractionary gap?

Answer 1

1.

In the given scenario, the government will use contractionary fiscal policy and under this policy, government spending will be reduced and or tax will be increased. As a central bank, monetary policy will be contractionary in nature. Regarding this, federal fund rate will be increased and money supply will be reduced by selling the treasury securities. It will reduce the aggregate demand and AD will shift to the left. As a result, long run equilibrium will be achieved.

2.

In the given scenario, the government will use expansionary fiscal policy and under this policy, government spending will be increased and or tax will be reduced. As a central bank, monetary policy will be expansionary in nature. Regarding this, federal fund rate will be decreased further and money supply will be increased by buying the treasury securities. It is termed as open market operations. It will increase the aggregate demand and AD will shift to the right . As a result, long run equilibrium will be achieved.