Question

After the global Financial Crises most of the economies implemented a fiscal and monetary policy mixes. Think about the big contraction in output after the global financil crises.

a) Write down the monetary policy reaction by the Central Bank. What would be the impact of this policy change on output and inflation using AS-AD model.

b) Write down the fiscal policy reaction by the government. What would be the impact of this policy change on output and inflation using AS-AD model.

c) What will be the total impact of the Monetary and Fiscal Policy on inflation, GDP and unemployment rate?

Answer 1

In response to the big output contraction due the global financial crises:

a. The central bank would respond by implementing an expansionary monetary policy. It would indulge in the open market operations and purchase government bonds that would increase the money supply in the economy. In the money market, with an increased money supply and an unchanged demand for money, the money supply curve would shift right that would lead to fall in the interest rates. At lower interest rates, the cost of borrowing is low. Thus, households and business enterprises would respond by increasing their spending on investment projects. Higher investment spending expenditure would boost the aggregate demand and shift the AD curve towards right. This would result in a higher aggregated output equal to the full potential level and higher prices as compared to the price level during the crises.

b. The government would respond by implementing an expansionary fiscal policy by either increasing its spending or by cutting taxes:

· Increased spending could be on economic projects such as transportation, infrastructure, education, healthcare etc which would create more employment opportunities. The government could also impose subsidies on purchase of necessary goods such as groceries, fuel, gas, electricity which would enhance the per capita spending capacity in the country.

· By cutting taxes, the disposable income of the tax payer would increase. People would have more consumption and spending capacity i.e. their purchasing capacity would increase.

In both the scenarios, aggregate demand would increase and the AD curve would shift rightwards. Thus aggregate income and output would rise along with an increase in price level.

c. The total impact of the monetary and fiscal policy would be boosting of the Aggregate Demand. The effects of the 2 policies can be analyzed with help of the below diagram.

- The X-axis shows Real GDP/Aggregate Output and the Y-axis shows the price level. Before the crises, the economy is at the long-run equilibrium point E1, where the vertical Long-run aggregate supply curve (LRAS), the short-run supply curve (SRAS) and the initial Aggregate Demand curve AD1 intersect. At the long-run equilibrium, the economy produces full potential/full employment level output Yn at equilibrium price level P1.

- After the global financial crises, the economy faces a huge demand shock that shifts the aggregate demand curve leftwards from AD1 to AD2. The economy moves to the new equilibrium E2. The price level falls from P1 to P2 and the output falls below the full potential level to Y2. Here economy faces a recessionary gap of “Yn – Y2”, leading to an increase in unemployment and lower incomes.

- In response to get the economy recovered from the recession, Central bank and the government implements expansionary monetary and expansionary fiscal policy simultaneously, both of which gives a boost to the aggregate demand as explained above.

- The aggregate demand curve shifts back upwards to AD1 and the economy is restored to the full employment equilibrium level. This cause’s demand pull inflation, that is price level rises from P2 to P1, unemployment decreases and real GDP increases from Y2 to Yn.