Question

Which of the Federal Government's Policy Tools should be used with the appropriate action to be taken to deal with the following economic situations?

1. Significant decreases in the real GDP for 3 straight quarters

2. Increases in the unemployment rate over the past 6 months

3. Monthly increases in the producer price index for the past 4 months

4. A severe depression

5. Significant increases in the CPI over the past 6 month

Answer 1

(1)

To increase real GDP, aggregate demand has to be increased using expansionary fiscal policy, by increasing government spending and/or by decreasing taxes. Lower personal income tax will increase consumption demand and lower business tax will increase investment demand.

(2)

Increase in unemployment rate indicates a recession in the economy. To increase real GDP, aggregate demand has to be increased using expansionary fiscal policy, by increasing government spending and/or by decreasing taxes. Lower personal income tax will increase consumption demand and lower business tax will increase investment demand.

(3)

Increase in producer price index indicates inflation which is caused by higher aggregate demand. To tame inflation, aggregate demand has to be decreased using contractionary fiscal policy, by decreasing government spending and/or by increasing taxes. Higher personal income tax will decrease consumption demand and higher business tax will decrease investment demand.

(4)

A depression is a longer-lasting recessionary period during which both aggregate demand and aggregate supply are low. To increase real GDP, aggregate demand has to be increased using expansionary fiscal policy, by increasing government spending and by decreasing taxes. Lower personal income tax will increase consumption demand and lower business tax will increase investment demand, so real GDP will increase from the demand side. At the same time, tax cut will increase business profitability, so firms will increase production and real GDP will increase from the supply side.

(5)

Increase in consumer price index indicates inflation which is caused by higher aggregate demand. To tame inflation, aggregate demand has to be decreased using contractionary fiscal policy, by decreasing government spending and/or by increasing taxes. Higher personal income tax will decrease consumption demand and higher business tax will decrease investment demand.