Suppose the U.S. economy faces
Suppose the U.S. economy faces a productivity slump, while atthe same time the federal government begins spending a lot of moneyon defense and social programs (this is akin to what happened inthe U.S. during the 1960s and 1970s). Assume wages are sticky inthe short run.
a. For each of the following variables, state whether it risesor falls, or whether the impact is ambiguous, after the two eventsdescribed above: real GDP growth rate, unemployment, and theinflation rate.
b. If the Fed was concerned about the inflation rate, whataction would it take regarding open-market operations? What impactwould this have on the federal funds rate and aggregate demand inthe economy?
c. What challenge does the Fed face in bringing the economy backto the real GDP growth rate it had before the productivity slumpand increase in government spending?
Answer:
US economy faces a productivityslump, meaning the GDP is declining. The federal government beginsspending more money on defense and social programs. Wages don’tmove and stay the same in short run.
a. Real GDP will grow because thegovernment has increased expenditure, this will be the key drivingfactor for a rise in real GDP growth rate. Unemployment will fallas government has increased expenditure, which will drive upemployment opportunities. Inflation rate rises as money circulatedin the economy rises.
b. Fed would reduce the money supplyin the economy, thus it will sell bonds to the market through openmarket operations, wherein money will be pulled back into thesystem. Federal funds rate would increase as the liquidity will below in the economy, thus there will be greater demand for credit,which will drive up the funds rate. Aggregate demand would dry upas less money starts circulating in the economy.
c. It has the trouble of higherfunds rate, which makes credit expensive, which reduces the chancesof industry investing in new technology. Thus it has to sustain theeconomy, wherein the economy doesn’t rely on governmentexpenditure, but instead private consumption and sustainable growthwhich has to drive GDP.
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