Answer to Question #158975 in Macroeconomics for Samama Ali

Question

a.      The Government of Bangladesh opted for expansionary fiscal policy to fight economic depression. Identify the type of inflation it is expected to create and its impact on the wages. Illustrate the process on the graph. (2.5 Marks, Maximum 150 words)

b.     Assume the Pakistan’s economy is in recession: Pakistan implements a combination of expansionary fiscal and monetary policy. In the absence of complete crowding out what will be the effect of these policies on each of the following: (2.5 Marks, Maximum 150 words)

           i. Aggregate demand in Pakistan

           ii. The price level in Pakistan

           iii. Interest rates in Pakistan

Answer 1

a.

An increase in government procurement will lead to a shift in aggregate demand from AD1 to AD2, to a state of short-term equilibrium (point E2). This situation will be characterized by an increase in prices for final products, a reduction in unemployment and an increase in the national product. This is the most favorable period. But after the rise in prices for final products, wages and prices for other factors of production will begin to rise. An increase in the prices of factors of production will lead to a fall in output, which will be accompanied by an increase in unemployment. The price growth will stop only at the point E3, at which the economy will return to the level of the natural real national product.

Thus, the result of fiscal policy will be a 50% price increase (points P1 and P3).

b. Complement fiscal expansion with monetary expansion by increasing the supply of money by an amount that will ensure the balance of the money market and compensate for the increased demand for money as a result of income growth (from Y1 to Y2) due to stimulating fiscal policy. This will keep the interest rate at the same level (R1). In this case, there will be a full multiplicative growth of the equilibrium income (from Y1 to Y3). This policy, aimed at maintaining a constant interest rate, was called the "pegging interest rate" policy. (However, it should be noted that in the long run, such a policy is fraught with inflation. If the central bank constantly increases the money supply in order to keep the interest rate unchanged, either in order to maximize the growth of total output, or in order to maintain the exchange rate of the national currency at a constant level, inflation is inevitable.)