Problem 1 (apt’93, p1)

Suppose that the following conditions describe the current state of the United States economy.

• The unemployment rate is 5 percent.

• Inflation is 2 percent.

• Real gross domestic product is growing at the rate of 3 percent.

1. First, assume that the federal government increases its spending and increases taxes so as to maintain a balanced budget. Using aggregate supply and aggregate demand analysis, explain the short-run effects of these policies on each of the following.

1. Output and employment

2. The price level

3. Interest rates

2. Now assume instead that the Federal Reserve buys bonds in the open market. Analyze the impact of this action on each of the following.

1. Interest rates

2. Output and employment

3. The price level

3. Analyze the combined effect of the two policy actions described above on each of the following.

1. Output and employment

2. The price level

3. Interest rates

Sample answer:

1. According to the balanced budget multiplier, an increase in government spending accompanied by an equivalent increase in taxes will bring about a rise in aggregate demand. Thus, AD curve will shift outwards, the result of which is illustrated in the graph below:

P AS - Due to the fact that unemployment is as low as 5%

we are justified in assuming that the economy is close

P ₁ to its full employment level, so that the AS curve has

a usual negative slope.

P ₀ AD₁

AD₀

Y₀ Y₁ Y

As you can see, both output and the price level will go up. Although it is not explicit in the above diagram, employment will also increase, as in the absence of any technological changes it always moves in line with the total output of the economy (the more firms produce, the more labor they need):

Y

Y₂ - production

Y₁ function

L₁ L₂ L – employment

To understand the effect of the above actions on interest rates the money market should be considered. The rise in output we identified earlier will cause an increase in transaction demand for money, which, together with a reduction in the real money supply due to higher prices, will raise interest rates:

i M^S₂ M^S₁

i₂

M^D₂

i₁ M^D₁

(M/P)

2. Buying bonds in the open market the Federal Reserve pumps money into the economy thereby increasing money supply. As the following graph shows, this will eventually lead to a decrease in the interest rates.

i M^S₁ M^S₂

i₁

i₂ M^D

(M/P)

The next stage will be an increase in investment demand, as lower interest rates render previously unprofitable projects more lucrative thus encouraging more investment. As a result, AD curve shifts to the right producing an increase in output, employment and the price level:

P AS

P ₁

P ₀ AD₁

AD₀

Y₀ Y₁ Y

3. If the two policies are implemented together, they will reinforce each other, generating a greater increase in output, employment and the price level than each of them would have generated on its own:

P AS

P ₁

P ₀ AD₁

AD₀

Y₀ Y₁ Y

Unfortunately, the effect on interest rates will be ambiguous and hard to predict. On the one hand, an increase in output and prices provoked by the changes in government spending and taxes will tend to raise interest rates. On the other hand, an increase in money supply resulting from the purchase of bonds by the Federal Reserve will work in the counter direction pushing interest rates down. Depending on the relative scale of the two policies any of the tendencies can prevail in the end. So, for instance, it is possible that the increase in money supply will be just enough to offset the effect of the fiscal expansion and interest rates will remain the same:

i M^S₁ M^S₂

i

M^D₂

M^D₁

(M/P)