East Malvidas: East Malvidas is a small island country with big economic problem

Question

East Malvidas: East Malvidas is a small island country with big economic problems. Currently the unemployment rate is 16 percent and the price level is increasing at a rate of 20 percent a year. Gross Domestic Product fell again this year, marking the second straight year of a prolonged recession. Income taxes (where the federal government receives most of its revenue) are highly progressive and the top marginal tax rate is 90 percent, impacting the incomes of 30 percent of the population. Over the past several years the money supply has been increasing at a 30 percent annual rate and the country has run both a federal budget surplus and a trade surplus. Tariffs on foreign goods are some of the highest in the world and many countries have retaliated by placing quotas on exports from East Malvidas. Thus, exports are a small part of the country’s economic output. With national elections two years away, the governing authorities are anxious to get the economy turned around before they have to stand for reelection. What types of monetary policy might be best for addressing the current situation (and which tools would you use to enact these policies)? What problems might your recommendations best address? Why?

Explanation / Answer

While typically expansionary monetary policy is recommended during a recession, the past, rapidly expanded money supply might take this suggestion off the table. To address the inflation problem, reducing the rate of growth in the money supply would appear to be the appropriate recommendation. The tools that would be recommend are higher interest rates, higher reserve requirements at banks, or selling government securities.

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