Question

a) Some economists claim that the government should always use monetary policy to stabilize (or target) the real interest rate in the short-run if they also wish to keep the resulting impact on (changes to) consumption to a minimum. Is this claim true, false or uncertain? Explain by using words and one IS/LM diagram.

b) The government should always use monetary policy to combat the effect of business cycle fluctuations coming from changes in autonomous government spending on goods & services if it wishes to keep movements in unemployment to a minimum. Is this claim true, false or uncertain? Explain by using words and a single IS/LM diagram.

c) The government should never use fiscal policy to combat business cycle fluctuations coming from changes in autonomous investment if it also wishes to keep longer-term movements in the price level to a minimum. Is this claim true, false or uncertain? Explain by using words and a single AS/AD diagram.

Answer 1

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Question:

Answer:

a). Answer:

Some economists claim that the government should always use monetary policy to stabilize (or target) the real interest rate in the short-run if they also wish to keep the resulting impact on (changes to) consumption to a minimum. Is this claim true, false or uncertain? Explain by using words and one IS/LM diagram.

Real interest rate is inflation adjusted interest rate. When inflation decrease then real interest increase and vice-versa. When Inflation is high then  the government decrease the money supply that increase interest rate that decrease aggregate demand in the economy. When AD decrease then its decreased total output and inflation level.

Suppose the current interest rate in the economy is "i1" when at money supply of "LM1" now government decrease the money supply then its LM curve shift upward/left. Here, interest rate is "i" and total output is "Y". Here interest rate has increased and price level decrease. It is a better solution to stabilize (or target) the real interest rate in the short-run. Increasing interest rate reduce the consumption level in the economy. But the level of decreasing Consumption is depends upon the how much interest rate is increased.  

b). Answer:

The government should always use monetary policy to combat the effect of business cycle fluctuations coming from changes in autonomous government spending on goods & services if it wishes to keep movements in unemployment to a minimum. Is this claim true, false or uncertain? Explain by using words and a single IS/LM diagram.

When autonomous government spending increase its increase the income level that increase the aggregate demand in the economy. Increasing AD level increase the the total output price level or inflation level. When the government use monetary policy then the central bank reduce money supply in the economy.

When inflation is high then  the government decrease the money supply that increased the interest rate . Increased interest rate decrease aggregate demand in the economy. When AD decrease then its decreased total output and inflation level both.The employment level is affected by production level and in short term production level is not fluctuate so, don't affect (increase) the unemployment level. In the time of recession the central bank adopt a expansionary monetary policy that increase money supply and decrease interest rate. Decreasing interest rate boost AD and increased AD boost total output and price level.

I have taken an example of expansionary phase. Suppose economy is in expansionary phase of business cycle. Here GDP growth rate and inflation rate both high.

Suppose the current interest rate in the economy is "i1" when at money supply of "LM1" now government decrease the money supply then its LM curve shift upward/left. Here, interest rate is "i" and total output is "Y". Here interest rate has increased and price level decrease. It is a better solution to stabilize (or target) the real interest rate in the short-run.

c). Answer:

The government should never use fiscal policy to combat business cycle fluctuations coming from changes in autonomous investment if it also wishes to keep longer-term movements in the price level to a minimum. Is this claim true, false or uncertain? Explain by using words and a single AS/AD diagram.

When autonomous government spending increase its increase the income level that increase the aggregate demand in the economy. Increasing AD level increase the the total output price level or inflation level. Here government can increase tax rates and decrease the government spending. Increasing tax rates and de creasing government income will reduce the expendable income/ income level then people will spend less that will decrease the AD level in the economy that decrease price level and total output level.

Suppose the currently economy is at equilibrium at "E1" where, equilibrium price and output level is "P1" and "Q1" respectively. Now government increase taxes and decrease spending then AD curve will shift right/downward that decrease the price level and output level. New equilibrium point is "E2". Equilibrium price and output level is "P2" and "Q2" respectively. In long the government can manage the price level by monetary policy. In the long run the LRAS (long-run AS cuve) is vertical.  It is saturation point and not have a scope for further growth. so, at this point increasing demand only increase the price level not output.

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