1. Aggregate demand

2. Output and the price level

3. Real interest rates

3. If the interest rate effects you identified in Part (b) continue in the long run, explain the impact of these effects on economic growth.

Sample answer:

1. One disadvantage of using trade restrictions to solve unemployment problems is rising prices of foreign goods, which will inevitably harm both domestic consumers and firms dependent upon imported resources. Another disadvantage is the possibility of trade wars, i.e. the situation when the governments of the most severely hurt countries decide to retaliate by taking similar measures with respect to domestic producers. This can give rise to a vicious circle, which is very difficult to break and brings nothing except losses to both sides involved in the conflict.

2. Monetary policy: One possible monetary policy action that may be used to bring unemployment down is a reduction in reserve requirements. This would allow banks to keep less money in cash and to lend out a bigger fraction of their deposits. Increased lending would ultimately lead to an increase in the total money supply, which, as the following graph shows, would push interest rates down, thereby encouraging more investment and boosting aggregate demand:

r M^S₁ M^S₂ r P AS

P₂

r₁ P₁ AD₂

r₂ I AD₁

M^D

(M/P) I₁ I₂ Investment Y₁ Y₂ Y

Thus, the policy would achieve the objective of raising output and employment, but only at the expense of higher prices.

Fiscal policy:

One way to address unemployment problems using fiscal methods is to increase the component of aggregate demand which is subject to direct government control, i.e. government purchases. The increase in aggregate demand this policy would lead to would cause both output and prices to grow in the short run:

P AS

P ₂

P ₁ AD₂

AD₁

Y₁ Y₂ Y

As a result of the output expansion, the demand for real balances will increase, hence, we would expect real interest rates to go up, the more so as supply of real balances will be reduced by the rise in prices:

r M^S₂ M^S₁

r₂

r₁ M^D₂

M^D₁

(M/P)

(c) In the case of expansionary monetary policy we observed a decrease in real interest rates (at least in the short run). This, of course, would have only a positive impact on economic growth, as investment, an important factor of economic development, is inversely related to the interest rate and would therefore increase in response to this change.

With fiscal policy, however, the effect would be opposite. The increase in the real interest rate would crowd out investment thus impairing long run economic growth.

Problem 4 (APT’96, P1)

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

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

• The inflation is 9 percent.

• The unemployment rate is 4.5 percent.

1. Identify the main problem this economy faces.

2. Assume the Federal Reserve decides to remedy the conditions described above by engaging in open-market operations. Describe the action the Federal Reserve would take. Using the aggregate demand-aggregate supply model, analyze the impact of this policy on each of the following.

1. The interest rate

2. Output and employment

3. The price level

3. Identify one limitation on the effectiveness of the monetary policy undertaken in (b).

4. Now assume instead that the Congress votes to increase personal income taxes. Using aggregate demand-aggregate supply analysis, explain what effect this policy will have on each of the following.

1. Output and employment

2. The price level

3. The interest rate

5. Identify one limitation on the effectiveness of the fiscal policy undertaken in (d).

Sample answer.

1. All characteristics of this economy seem to be within the normal limits, except one – the rate of inflation appears to be too high.

2. To bring the inflation down the Fed must use a contractionary monetary policy. If it decides to engage in open market operations then the appropriate action would be to sell bonds. Doing this would result in a reduction in the money supply and, as the following graph indicates, push the interest rate up.

i M^S₂ M^S₁

i₂

i₁ M^D

(M/P)

The decline in investment brought about by this rise in the interest rate would decrease the aggregate demand causing both prices and output to fall (see the graph below):

P

SAS

P ₁

P ₂ AD₁

AD₂

Y₂ Y₁ Y

With decreased output firms will need less labor and therefore employment will decrease as well.

c) The monetary policy will be ineffective if investment demand is not sensitive to changes in the interest rate or, conversely, if the demand for money is excessively responsive to changes in the interest rate.

d) Increasing personal income taxes would reduce consumption demand causing a leftward shift in the aggregate demand curve:

P

SAS

P ₁

P ₂ AD₁

AD₂

Y₂ Y₁ Y

Just like in the case of the contractionary monetary policy described above, this fiscal policy will produce a decrease in output and employment and make the price level go down.

With a lower level of output people will need less money to go about their activities. Hence, the demand for money will decrease resulting in a drop in the interest rate.

Furthermore, since the output contraction will be accompanied by declining prices, the supply of real balances will increase making the interest rate fall still more.

i M^S₁ M^S₂

i₁

M^D₁

i₂ M^D₂

(M/P)

e) The fiscal policy will be ineffective if the investment demand is very responsive to changes in the interest rate. In this case, even a slight decrease in the interest rate will encourage more investment almost completely offsetting the contractionary effect of the increase in personal income taxes.

Problem 5 (APT’99, P1)

Following an increase in the demand for money, an open economy is experiencing a significant increase in real interest rates relative to the rest of the world.

1. Explain how this increase will affect each of the following for the country.

1. Investment

2. The international value of its currency

3. Exports

2. Using a correctly labeled aggregate demand and aggregate supply diagram, show how the change in investment you identified in part (a) will affect each of the following in the short run.

1. Output

2. The price level

3. Identify one fiscal policy action that could counter the effects identified in part (b). Explain how this policy will affect each of the following.