Question

Identify the appropriate policy mix for different economic problems. Here are some examples: oil price shock, slow capital formation; growing budget deficit. Suppose you are the fiscal authority; how would you respond to each problem? What response would expect or hope to see from the monetary authority (the central bank)? What trade-offs will you need to confront?

Answer 1

In case of oil price shock and slow capital formation in the economy aggregate supply curve of the economy will shift leftwards. This reduces the growth rate of output in the economy. In order to overcome this fall in the growth rate, expansionary monetary and fiscal policy is needed which will shift the aggregate demand rightwards and thus overcome recessionary conditions from the economy.

Growing budget deficit will lead to fall in government spending to overcome the deficit and increases tax revenue of the government. This reduces the overall national output of the economy and reduces aggregate demand in the economy. To overcome the fall in national output, expansionary monetary policy of the Fed is needed to increase aggregate demand and thus prevent fall in the level of national output in the economy.