Question

ShortQuestion 1 (10%) If the economy is entering an expansionary period, explain two different types of policies you would recommend to keep growth and inflation under control. in each case, explain the main effects of these policies drawing an ADIAS Chart and defining how ADIAS would shift / move.

Answer 1

Two policies are as below:

No.1) Decreasing bank interest rates: This is an expansionary monetary policy, which is taken by the central bank (Federal Reserve). Once the interest rate becomes low, the demand for loan increases; it increases investment opportunity, since money supply in the market increases. More investment means more job opportunity, more GDP, which shifts the AD curve to the right direction.

No.2) Increasing income and sales tax rates: Since there is expansionary monetary policy, the income of consumers would also increase. It increases purchasing ability of those consumers; they demand for more goods, which turn into inflation. In order to restrict such demand the income tax rate could be increased. Income tax reduces disposable income, which is the way of cutting excess demand. On the other hand, increasing the sale tax rate reduces the aggregate supply (AS); it shifts the AS curve to the left direction, making the inflation down.

Graph: Price level AS1 AS ADI I01 P1 E1 לאו Aggregate output, Y

The AD curve is downward slopped, since there is an inverse relationship with the price level. The AS curve is upward slopping because of positive relationship.

Since there is a decreasing interest rate, AD would shift to AD1 initially. Since there is an increasing tax rate, AS would shifts to AS1. The equilibrium is E and the price is higher as P.

Now, there is the tax effect on consumers; it shifts AD1 to AD2 and makes E1 equilibrium with AS1. The inflation is controlled here, since price drops to P1. The E1 point ensures the growth as well, because its output is higher than the output of initial (AD = AS).