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Fiscal Policy and Government Spending

Two important policy goals of the government and the Fed are to keep unemployment and inflation low, while at the same time making sure that GDP is increasing at an average of 3% per year. It is important to have the right mix of policies and that all the variables be timed perfectly.

Part 1: Assume that the country is in a period of high unemployment, interest rates are at almost zero, inflation is about 2% per year, and GDP growth is less than 2% per year.
- Suggest how fiscal and monetary policy can move those numbers to an acceptable level keeping inflation the same.
- What is the first action you would take as the president? As the chairman of the Fed? Why?
- What would be your subsequent steps?
- Make sure you include both the positive and negative effects of your actions, and include the trade-offs or opportunity costs.

Include the following concepts in your discussion:
- Demand and supply of money
- Interest rates
- The Phillips curve
- Taxation
- Government spending
- Wages
- Costs of inflation
- The multiplier and the tax multiplier
- The idea of tax rebates to stimulate the economy

Part 2: Assume that the country is in a budget deficit and carrying a very large debt. Discuss the dangers of a high debt to GDP ratio and a growing budget deficit. Would this affect any policy changes you discussed in Part 1?

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Solution Preview

Part 1:
Policy target is for GDP growth or reducing unemployment amid stable inflation. During the period of low interest rates, the suitable policy action is through fiscal policy such as:
- Increasing government spending (G). The president should implement more fiscal packages like public projects such as building schools, hospitals, infrastructures etc. This is direct injections to the economy and creating more jobs; or
- Stimulus packages to promote private consumption. This can be done by tax cuts or tax rebates. People will have more disposable income for consumption. The effectiveness of this policy to increase aggregate demand depends on the public's marginal propensity to consume (MPC). The greater the ...

Solution Summary

During a period of low interest rates, monetary policy is ineffective. This is called a liquidity trap. People demand more cash in relation to other interest-bearing assets such as stocks and bonds. This solution discusses fiscal policy that should be used in this situation to stimulate growth while maintaining lower price level in the economy. It also discusses policy tools, including government spending or tax rebates.