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
The Phillips curve
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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Maintaining a low level of unemployment as well as a low inflation rate are part of the dual mandate of the FED. The possibility of having low inflation and low unemployment is given by the Philips curve – it provides policy makers with a trade-off between inflation and unemployment in the short run.
A government can keep unemployment under check and allow inflation OR it can keep prices under check without being able to control unemployment. This trade-off is shown as a negative relation between inflation and unemployment. In the long run the curve is vertical at natural rate of unemployment, so that there government has no control over unemployment, it can only manipulate the inflation rate.
The present situation given in the case is that of a Liquidity Trap where-in the U.S. economy is experiencing a nominal rate of near zero percent. As the expansionary monetary policy works by reducing the interest rate, the policy will be ineffective since the rates are already at a historical low of near zero percent.