Answer to Question #205424 in Macroeconomics for levy

Question

n the North Island economy, all domestic production is consumed domestically, and there is no import of foreign goods. The policy makers in North Island fear that the domestic production is too high, which may lead to inflation in the longer run (even though we assume a constant price level in the short run). At the same time, it is an election year, and the sitting government has promised to not decrease the households’ disposable income.

 

A) What can the government in North Island do to improve this situation? 

Answer 1

Solution:

The situation arising in the North Island economy is referred to as cost-push inflation. It is the decrease in the aggregate supply of goods and services resulting from an increase in production costs. It arises when the country experiences rising prices due to higher costs of production and higher costs of raw materials.

The government in North Island can, therefore, adopt measures such as supply-side policies with the aim of increasing the aggregate supply and counter cost-plus inflation. Also, the government can decrease taxes and the central bank can adopt contractionary monetary policies through increasing interest rates to increase the aggregate supply.

The supply-side policies implemented by the government in North Island, such as deregulation of financial markets, privatization, lowering income tax rates, limiting the power of trade unions, higher government spending on transport, education, and communication, can spur productivity and increase efficiency in the economy. In the long run, these measures will shift the aggregate supply to the right and enhance higher economic growth reducing cost-plus inflation.