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Concurrent Fiscal and Monetary Policy

Please can you help with this part of my revision:

Imagine a standard aggregate demand and aggregate supply set-up. As you know, the British government has been reducing government expenditures to reduce fiscal deficit and government debt.

A. Using this framework, show the effect on aggregate demand and supply and output, assuming that before this new fiscal policy, the economy was in long-term equilibrium. Show where you would expect the new short- and long-run equilibrium.
B. For short-term analysis: What would be the multiplier of this austerity program if MPS is 0.2, MPM is 0.1 and MPT is 0.2?
C. How can monetary policy ease the pain of austerity? Illustrate in the graph.
D. Critics argue that this program can do long-term damage to the British economy. Using the same aggregate demand and aggregate supply framework, show how this would work. Provide economic arguments.
E. Unemployment often takes a long time to decrease even after the economy has exited a recession, though it eventually will. There is often a fear, however, that this time the unemployment rate will stay constantly high. Discuss the two sources of unemployment behind these two arguments.



Solution Summary

The contractionary fiscal policy may bring down government budget deficit. However, it will lead to unemployment. If it is used concurrently with expansionary monetary policy, output will be restored at the initial level and no effect on the price level. However, some critics argue that this twin policies may be inflationary due to stronger currency, which in turn, will encourage import demand.