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American Recovery and Reinvestment Act

A.Under the American Recovery and Reinvestment Act of 2009, the federal government is undertaking a large fiscal stimulus, about $800 billion, or more than 5% of GDP, to be spent over the next several years.

Using the AS/AD framework, explain the rationale and likely effect of this fiscal stimulus program. How large an effect on GDP would you expect the stimulus program to have, and why?

Consider and respond: Every dollar of government purchases of goods and services generates employment, so what the $800 billion in federal stimulus money is spent on does not matter.

B.Using the Phillips Curve approach, explain why the inflation rate increases when the unemployment rate decreases?

What is the Taylor Rule? Explain why the Federal Reserve would increase the real interest rate if the inflation rate rose.

C.Niall Ferguson, a financial historian and professor of history at Harvard University, recently wrote an article for the Financial Times, entitled "A Greek Crisis is coming to America." http://www.ft.com/cms/s/0/f90bca10-1679-11df-bf44-00144feab49a.html Summarize briefly the issues contained in the article. Is America at risk of a debt crisis ala Greece? Why or why not? Will the "financial crisis" narrowly defined end soon? What about the broader forces at work? How can the US handle the rising fiscal burdens associated with desirable spending but also with rising deficits and debt? [Hint: There is the fiscal pessimist camp-Carmen Reinhart and Ken Rogoff, members; and fiscal sanguine camp-Paul Krugman.]

Solution Preview

See the attached file "fiscal." The economy is at first at Y1 and P1. Increasing government spending shifts the AD curve outward and causes a temporary increase in national income, from Y1 to Y2. This is the rationale for spending stimulus packages. If each dollar injected into the economy multiplies by some factor greater than one, and thus the actual increase in Y will be greater than the increase in government spending. However, if the multiplier is less than one, each dollar of spending will cause less than a dollar increase in Y. Thus the effect on GDP is going to depend on the value of the multiplier, which is highly debatable. For estimates of the multiplier for different types of spending, see page 12 of this CBO document: www.cbo.gov/ftpdocs/106xx/doc10682/11-30-ARRA.pdf

For an opinion on why it may be less than one, see http://online.wsj.com/article/SB10001424052748704471504574440723298786310.html

Others believe the multiplier may even be negative, due to declines in private investment that accompany increases in government debt. For more on this see http://www.themoneyillusion.com/?p=2512

These arguments related to smaller multipliers are based on long term effects. In the graph, we can see that the the outward shift iin the AD curve causes the price level to increase from P1 to P2. This eventually results in a backward shift in the short run aggregate supply curve from SAS1 to SAS2. The end result is the ...

Solution Summary

Using the AS/AD framework to explain the rationale of the ARRA