Assume that the country is in a period of high unemployment, interest rates are

Question

Assume that the country is in a period of high unemployment, interest rates are at almost zero, inflation is about 2% per year, and GDP growth is less than 2% per year. Suggest how fiscal and monetary policy can move those numbers to an acceptable level keeping inflation the same. What is the first action you would take as the president? As the chairman of the Fed? Why? What would be your subsequent steps? Make sure you include both the positive and negative effects of your actions and include the trade-offs or opportunity costs.

Explanation / Answer

This is a situation of liquidity trap, where the economy is experiencing a nominal rate of near zero percent. As the expansionary monetary policy works by reducing the interest rate, the policy will be ineffective since the rates are already near zero.

The best monetary policy at this juncture is to create expectations for the public that the Fed is going for an expansionary monetary policy in the near future and thus increasing the inflationary expectations. This would decrease the real interest rates leading to investments.

However, the economic situation presented above represents an insufficient demand. Any policy targeted to increase in output will be counterproductive. Instead, we have to apply policies to increase the demand.

The Fiscal policy that can be implemented here are specific tax cuts and increasing specific government spending.

Specific tax cuts: Should not labor taxes or capita taxes. Cutting labor taxes increases employment at the initial level but decreases productivity, wages and increases deflationary pressures. On the other hand, cutting capital taxes increases savings at the expense of current spending. Thus, these two policies should be avoided as they are contactionay or counterproductive.

Therefore, to increase demand there should be a reduction in the sales tax, increase in the tax credit and an increase in government spending. The government spending should be in areas where it will not reduce the funds available for private investments.

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