Problem 2 (apt’94, p1)

Suppose that the following statements describe the current state of an economy.

• The unemployment rate is 5 percent.

• The inflation is at an annual rate of 10 percent.

• The prime interest rate is 11.5 percent.

• The annual growth rate of real gross domestic product is 5 percent.

1. Identify the major problem(s) the economy faces.

2. Describe two fiscal policy actions that could be used to alleviate the problem(s). Using the aggregate supply and aggregate demand model, explain how the actions you identified will affect each of the following.

1. Output and employment

2. Price level

3. Nominal interest rates

3. Instead of using fiscal policy to solve the country’s problem(s), use only monetary policy. Describe two monetary policy actions that could be used to alleviate the problem(s). Using the aggregate supply and aggregate demand model, explain how the actions you identified would affect each of the following.

1. Nominal interest rates

2. Output and employment

3. Price level

Sample answer:

1. As follows from the given figures, the major problem the economy is facing is high inflation rate.

2. To lower the rate of inflation contractionary fiscal policy should be implemented, such as

1. increasing personal income taxes, or

2. cutting government expenditure

In both cases, the direct effect of the policy will be a decrease in the aggregate demand (either through consumption expenditure or government purchases). As the following diagram shows, this will result in a contraction of output and a fall in the price level:

P

SAS

P ₁

P ₂ AD₁

AD₂

Y₂ Y₁ Y

As lower output implies that now firms need less labor, employment will go down as well.

The effect on the nominal interest rates can be examined within the framework of the money market. As illustrated in the graph below, the reduction in income will produce a decrease in the demand for money, which, combined with the simultaneous increase in the supply of real balances caused by the drop in prices, will lead to a fall in interest rates:

i M^S₁ M^S₂

i₁

M^D₁

i₂ M^D₂

(M/P)

3. To tackle the inflation problems using monetary apparatus the Central Bank could do either of the following:

1. sell bonds in the open market, or

2. raise reserve requirements.

Both actions would reduce total money supply, thereby pushing interest rates up and discouraging investment:

i (M/P)^S₂ (M/P)^S₁

i₂

i₁

M^D

(M/P)

The fall in investment would cause aggregate demand to decrease bringing about a reduction both in output and prices:

P

SAS

P ₁

P ₂ AD₁

AD₂

Y₂ Y₁ Y

Problem 3 (apt’95, p1)

Over the past two years, the unemployment rate in Country X has risen from 5 percent to 9 percent. As the leader of Country X, you have been presented with two policy options to address the unemployment problem.

Policy 1: Use tariffs and quotas to restrict imports and thus protect jobs in Country X.

Policy 2: Use monetary and fiscal policies to solve the unemployment problem without resorting to trade restrictions.

1. Explain two disadvantages of selecting Policy 1.

2. Describe in detail one specific monetary policy action and one specific fiscal policy action you would take to reduce unemployment. Explain how each of these actions would affect each of the following in the short run.