36. Consider a depressed economy that, even after significant monetary stimulus efforts that pushed short-term interest rates to close to zero, still experiences a recessionary gap of 1,200 billion dollars and 10 % unemployment rate. Economist estimate that the marginal propensity to consume is 0.75. Adress the following questions, briefly justifying all your answers. a) Would an increase in the money supply by the Fed help reduce the recession and the unemployment ? Explain why or why not? b) Could an increase in government purchases help? If so, what increase in government purchases would close the gap and restore full employment ? e) How about a tax cut ? If so, a tax cut what size would do the trick ? d) In order to evaluate whether government spending or tax reductions are more efficient in restoring full -employment , try to evaluate whether any one of these policies would restore full - employment with a smaller increase in the government budget deficit ? (Hint : compare the respective budget deficits in (b ) and ( c)) . e) Is there any alternative policy that could restore full employment without increasing the budeget deficit ? Describe it .
a) Increasing the money supply by the Fed would help reduce the recession and unemployment to some extent. When the Fed increases the money supply, it makes it easier for individuals and businesses to borrow and spend. This increased spending can stimulate economic activity and potentially reduce the recessionary gap. However, it might not be sufficient on its own to completely eliminate the gap and achieve full employment.
b) An increase in government purchases can be an effective policy tool to reduce the recessionary gap and restore full employment. By increasing government spending, there will be a rise in demand for goods and services, which can boost economic activity and lead to job creation. The increase in government purchases needed to close the gap and restore full employment would depend on various factors, such as the size of the gap and the multiplier effect of government spending.
c) A tax cut can also be a tool to stimulate the economy and reduce unemployment. When individuals and businesses have more disposable income due to lower taxes, they are likely to increase their consumption and investment, which can contribute to economic growth. The size of the tax cut needed to close the gap and restore full employment would depend on the responsiveness of individuals and businesses to changes in tax rates.
d) To evaluate which policy would be more efficient in restoring full employment with a smaller increase in the government budget deficit, you would need to compare the respective budget deficits in (b) and (c). It is important to consider the multiplier effects of government spending and tax cuts and assess which policy can generate a greater increase in economic activity and employment per dollar of additional deficit spending.
e) An alternative policy that could restore full employment without increasing the budget deficit is an increase in exports. If the economy can stimulate demand for its goods and services from foreign countries, it can lead to an increase in production and employment without relying on government spending or tax cuts. However, this depends on the global economic conditions and the competitiveness of the country's exports. Increasing exports may require strategies like improving competitiveness, trade agreements, or exploring new markets.