Consider an economy characterized by the following information. Potential output
ID: 1198245 • Letter: C
Question
Consider an economy characterized by the following information.
Potential output/Natural rate of output = $850 billion per year
Current output = $830 billion per year
Natural rate of employment = 4% unemployment rate
Current unemployment rate = 5.2%
Price stability/Inflation target = 0-3% inflation per year
Current inflation rate = 8% inflation per year
Current budget deficit = 2.4% of GDP
Real interest rate = 5% per year
The following are the current expenditure levels for this economy. All figures are in billions of dollars per year and should be labeled as such for full credit on the final test!
C = 10 + .9(Y - T) - 100r
I = 60 - 200r
G = 200
T = 180
EX = 20
IM = 30
If you were an economic advisor to the President of this country, what policy or policies would you recommend and why? Is there a downside to your recommendation? Are you considering the short-term, the long-term or both?
In order to write a thorough, organized answer, you should begin by identifying all of the problems in this economy. You should have both a short-term and a long-term policy. You should explain why you’re choosing the policy or policies you’re recommending and what the trade-offs or downsides are. Clearly there are no right or wrong answers, just well-reasoned or less well-reasoned ones.
I. Identify all of the problems in the economy.
Be as specific as possible. Use numbers wherever you can.
II. Short-term Policy
A. Which problem do you want to tackle first and why?
B. Which policy tool will you use and why? Be as specific as possible, using numbers where appropriate.
C. What are the trade-offs?
III. Long-term Policy
A. Which problems do you have left to deal with?
B. What specific policy tool do you recommend and why? How does it address the remaining problems.
And it's certainly fair game to consider political as well as economic factors.
Explanation / Answer
Current output, Y = $830 billion
Nominal rate (r) = Real rate + Inflation rate = 5% + 8% = 13%
GDP = C + I + G + (EX – IM)
= {10 + 0.9(Y – T) – 100r} + (60 – 200r) + 200 + (20 – 30)
= {10 + 0.9(830 – 180) - 100×13%} + (60 - 200×13%) + 200 – 10
= $806 billion
1.
Problems in the economy:
a. The amount of tax 180 is much below at the current level of output (Y). It should be around 30% to 40% of $830 billion. Suppose at 40% rate, tax would be (830 × 40% =) 332. Higher tax at higher income is required to increase the earnings of the government and to reduce budget deficit.
b. The economy is facing negative net export. It means import is higher than the export. This is not good for the economy, since foreign currency diminishes. The government has to impose higher tariff on import so that import could be less than the export and the net export could be positive.
c.
Inflation rate, 8%, is higher than the real interest rate, 5%. This is a serious economic problem. It means the growth of the economy, interest earnings, is lower than the expense, inflation. The government has to restrict money supply through imposing higher interest rate. Once the money supply is controlled, inflation rate would be decreased.