2.In the Short-run, the Effect of an Expansionary Fiscal Policy on the output level is very large when money Demand is highly sensitive to the Changes in the Interest rate. Do you agree or disagree with this Statement?
3.Suppose an Economy characterized by Flexible Prices and Rigid Nominal Wage in the short-run. Using Aggregate Demand—Aggregate Supply framework, Discuss the Short-Run and long-run Effects of an Increase in Money Supply on the price level, real GDP, Nominal wage rate and real Wage rate.
1.The main target of any policy maker is to increase the level of GDP within an economy to an unattained level. The policies taken up by the policy makers depend on the type of economy under which he is subjected to enact. In this case, we have to consider the economy to be a closed one. In other words, the nation is not involved into trade with the global economy but only within itself. Now the policy maker has only two tools to operate with in order to bring about any changes in the economy. They are fiscal policy and monetary policy.
Monetary policy: This policy consists of changing the money supply available within an economy at any particular time. It is taken up by the monetary authority of any nation that is the Central bank of any country. Monetary policy can either be positive in nature that is expansionary policy or negative in nature that is contractionary policy (Kriesler and Nevile 2016).
Fiscal policy: This policy is directly in the hand of the government through which they try to control the nation. They can either change the tax rate or the general spending level to manage the economy (Rubin and Lange 2014).
The given scenario is that there should be some policies taken up by the government within the closed domain so that the interest rate remains stable while leading the economy in its growth path. Henceforth, the suggestion is that the policy maker can use both expansionary monetary and fiscal policies. In the short run, taking up expansionary policies is not going to affect the interest rate but keep it at the equilibrium level (Bella, Mattana and Venturi 2014). The level of economic output is going to increase though in both short and long run. In other words, the GDP of the nation is expected to get uplifted. In the long run, these policies are going to affect the economy by increasing the price level and hampering the real wages earned by the workers within the economy. The diagram below describes the economic situation that is expected to occur if expansionary policies have been taken up within the economy.
Figure 1: Expansionary policies through IS-LM
Source: Created by the Author
The above IS-LM diagram shows the actual effect of both the expansionary policies within the given nation. At the initial level an expansionary fiscal policy is going to shift the interest rate above r and increase the output level to Yo. Through this policy the government can increase the level of their expenditure and reduces the tax rate so that people now have more disposable income in their hand (Matsumoto and Szidarovszky 2016). Since, it has been given that the government wants to keep the interest rate unchanged, hence they also takes up expansionary monetary policy to keep a check on the rise in interest rate due to fiscal expansion. Having more money implies people are now being able to purchase more goods and services and hence the demand for those goods increases in turn increasing Y1 from Yo. At the same time the interest rate goes down again back to its initial level. Hence, it can be stated that within a closed economy a mix of both the expansionary policies is going to bring out the desired outcome of increased output while keeping the interest rate steady.
2.I strongly disagree with the statement given in the question that in short run there is a very large impact on the level of output with adoption of expansionary fiscal policy. In order to justify the point of disagreement there is a need to explain this concept with the help of the following Investment-Savings Liquidity Money (IS-LM) diagram.
Figure 2: Money Supply & IS-LM curve
Source: Created by the Author
Fiscal policy, the only direct tool in the hand of the government to control the economic disturbance within a nation is only effective properly only in the short run (Nakamura and Steinsson 2015). The government might take up contractionary or expansionary fiscal policy depending on the way in which it wants to control the nation. The government takes up expansionary fiscal policy whenever it wishes to increase the level of aggregate demand within the economy. This can be done by the government either by lowering the tax rate or by increasing the planned expenditure on government or by applying both (Adam and Billi 2014). Mathematically, aggregate demand is written as: AD = C + I + G + (X – M). Here, if government increases the planned expenditure, that is the component G, keeping everything else as it is the AD increases.
According to the question, there is going to be a large increase in the level of output when money supply remains sensitive (Hansen 2013). In the diagram above it has been seen that whenever there has been an outward shift in the IS curve, there is going to be increase in the level of Y and also r. The interest rate r is going to increase as shown by the red coloured arrow in the above given diagram. On other hand an increase in interest rate is inevitably followed by an expansion of money supply within the economy leading to inflation and thereby contraction of the economy via reduced production. Hence, in order to have a huge increase in the volume of output level the money supply has to be insensitive to the changes in the interest rate and remain fixed at the place where it presently is lying. Only when money supply is insensitive to the fluctuation in interest rate, there is going to be a large expansion in the volume of output followed by a sharp rise in the level of interest rate (Arrow and Kruz 2013). Otherwise, crowding out would take place had money supply being sensitive to the interest rate as mentioned in the question. Hereby, the disagreement of the proposed statement from the question has been justified.
3.The exchange rate can be interpreted in the way in which the currency of home economy is interpreted in terms of the currency of the other economy (Afonso and Balhote 2014). There are two types of exchange rate depending on the rigidity of the economy as set up by the government. They are fixed exchange rate and floating or flexible exchange rate. In answering this question, it has been considered that the economy is operating under flexible exchange rate. In other words the government of the nation allows the currency to fluctuate and adjust itself in accordance with the currency of other nation (Goodwin et al. 2013). Now the effect of this price system in short run and long run has been discussed below.
Figure 3: Short Run AD-AS
Source: As Created by the Author
Usually in the short run, it is difficult to increase the money supply within an economy but still if money supply can be increased in the short run the consequent effect of the same within the economy has been discussed. With the increase in the money supply people’s demand for goods and services is going to increase. The consequent result of this is going to be a shift in the AD curve in the rightward direction (Mankiw 2014). Similarly in the short run the aggregate supply curve is upward sloping and it is not possible to increase the supply within the economy as supply works with the feature of time-lag. It has been shown in the above figure from AD to AD1. The effect in other sector of the economy has been discussed below:
Effect on Price Level: Price level is going to increase from P* to P1 with the shift of the AD curve.
Effect on Real GDP: The figure above clearly highlights that with the increase in demand and shift of AD curve, there has been an increase in the Real GDP from Y* to Y1.
Effect on Nominal Wage Rate: Nominal wage rate is going to increase as a consequence of increased demand and production. Moreover with the increase in money supply people is going to feel that they are earning more than before.
Effect on Real Wage Rate: As price level also increased henceforth often it results to a counter impact on the wage rate. The nominal wage rate may seem to increase but in reality the real wage is going to stay as it was or people may even be worse-off.
In the long run the aggregate supply curve is vertical in shape. This is because all the resources are considered to be used optimally to produce the best possible result (Sikdar 2014). Therefore, the impact of increased money supply has been discussed below.
Figure 4: Long Run AD-AS Curve
Source: As Created by the Author
Effect on Price Level: Price level is going to increase as shown in the figure from P* to P1.
Effect on Real GDP: Real GDP is not going to change as LRAS is now vertical. It is going to remain stagnant at Y.
The nominal wage rate might increase but the real wage rate is not guaranteed to increase as there is going to be high price level in the economy
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