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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.

Thanks,

RK

Solution Preview

Hi RK,
thanks for asking me. I will try my best to answer your questions. I hope this will help.

All answers are in the attached file. Thanks

A) Initially the economy is in the long-run equilibrium, where output is at the natural rate of output at the Yn. The AD and AS curves relevant to the economy are AD1 and AS1, respectively. The price level in the economy is P1. With the policy of a reduction in the government expenditures, AD shifts to AD2. In the short run AS cannot adjust. The price level now is P2. However, at this price output (Ys) is below the natural rate Yn. In the long run, suppliers will adjust their production to bring the economy back at the LRAS, hence, AS shifts to AS2. As a result, price settled at a lower level, P3.

B) The spending multiplier is: ...

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.

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