Gee's economy is in short-run equilibrium with an inflationary gap of $50 billion, and the marginal propensity to consume is 0.5. The expected inflation rate is 3%, and the
natural rate of unemployment is 3%.
(a) Based on the Phillips curve model, is the actual inflation rate greater than, less
than, or equal to the expected inflation rate of 3% in Gee? Explain.
(b) Assume the government takes no policy action with regard to the state of Gee's
economy.
(i) What will happen to inflationary expectations in the long run? Explain.
(ii) How will the long-run adjustment process be represented in the aggregate
demand-aggregate supply model? Explain.
(c) Assume that instead of waiting for the long-run adjustment, the government of
Gee is considering using fiscal policy to address the inflationary gap of $50 billion.
(i) If the government chooses to decrease its deficit spending, calculate the minimum
change in government spending required to decrease aggregate demand by the
amount of the inflationary gap. Show your work.
(ii) How will the effect of the government's action in part (c)(i) be represented in the
Phillips curve model? Explain.
(iii) If the government chooses to increase income taxes instead of decreasing its
spending, calculate the minimum change in income taxes required to decrease
aggregate demand by the amount of the inflationary gap. Show your work.
(iv) Now suppose instead that the government wants to maintain a balanced budget
and decreases both government spending and income taxes by $40 billion. Will this
policy make the output gap smaller, make the output gap larger, or have no effect on
the output gap? Explain.
(d) Suppose the government chose to implement only the policy described in part (c)
(i). Based on loanable funds market analysis, what will happen to each of the
following?
(i) Real interest rates in Gee. Explain.
(ii) Private savings. Explain.
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