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Q2. Effects of fiscal stimulus Read the attached article published in the Financial Times on June 29, 2009. The Chairwoman of the Council of Economic Advisers, Christina Romer, argues that the fiscal stimulus enacted in early 2009 will have a significant effect on US economic activity. This question attempts to clarify the mechanisms by which this should occur, using the AD/AS model. Assume throughout that the central bank does not change its monetary policy. a) Assume that the US economy begins in a situation in which actual GDP (Y) is below the potential level of GDP (Y"). Illustrate this situation in the AD/AS diagram, labeling the initial equilibrium point A. [Hint: recall that actual output is always on the AD and the AS curves]- b) Consider now the IS diagram. Suppose that the government increases government expenditures (G) on purchases of goods and services, does not undertake new investment expenditures, and keeps taxes unchanged. Assume (for now) that the interest rate remains constant. 1 . Keeping the interest rate constant, what is the effect on the aggregate demand for goods and services? 1i. Keeping the interest rate constant, what is the effect on the demand for investment and consumption goods? ili. How does the IS curve shift in the IS diagram? (Draw the shift) c) Turning back to your AD/AS diagram derived in part a): 1. Draw the shift (if any) of the AD curve, due to the increase in government expenditures. ii. Does the increase in G have any effect on the MP curve or the AS and LRAS curves? ili. Determine the short-run equilibrium following the increase in government expenditures, labeling this new equilibrium point B. At this point, what do you expect should happen to inflation compared to point A? Is the real interest rate at point B higher or lower than in point A? [Hint: Consider the Taylor principle in your answer]- iv . In the short-run equilibrium B, is consumption and investment higher or lower compared to point A? v. As we approach the medium run, which curve do you expect should move in the AD/AS diagram? Draw the shift and label the medium run equilibrium point C. d) Given what you found in part c), comment on the following quote from the Financial Times article: Even so, Ms Romer warned against tightening [...] fiscal stimulus prematurely. She said the authorities should continue to work on their exit plans but not implement them until the economy came back strongly. 'It is important to think about it now but policymakers should not start acting until we are really recovering well and are approaching full employment." Ms Romer, an expert on monetary policy, said she thought the risk of inflation was "very low" "With unemployment and unused capacity high, it is not as if inflation is going to creep up on us. We will have a long period of time to figure out what to do." Do you agree with Ms Romer' statements? (Answer briefly).Romer upbeat on economy Print By Krishna Guha in Washington Published: June 29 2009 03:D0 | Last updated: June 29 2009 03:00 The US economy will feel a substantial boost from the Obama administration's emergency spending package over the next few months,says Christina Romer, a senior White House official, who has warned against tightening monetary and fiscal policy before recovery is well established Ms Romer, chairman of the US president's council of econ-omic advisers, told the Financial Times in an interview she was "more optimistic" that the economy was close to stabilisation. But while hopeful that America could yet experience a V-shaped recovery, she said it was much too soon to begin ightening policy: "We do not want to repeat the mistake Japan made in the 1990s, when the moment things started to improve they tightened policy." Meanwhile, David Axelrod, a senior White House adviser, told NBC Television yesterday the administration would be open to further stimulus if needed. "Let's see in the fall where we are, but right now we believe what we have done is adequate to the task. If more is needed, we'll have that discussion." Ms Romer's comments come as opposition Republicans step up their attacks on the $787bn fiscal stimulus, pointing out that it has not prevented unemployment from hitting a quarter-century high of 9.4 per cent. Ms Romer said stimulus spending was "going to ramp up strongly through the summer and the fall". "We always knew we were not going to get all that much fiscal impact during the first five to six months. The big impact starts to hit from about now onwards," she said. Ms Romer said that stimulus money was being disbursed at almost exactly the rate forecast by the Office of Management and Budget. "It should make a material contribution to growth in the third quarter." But she acknowledged that cutbacks by states facing budget crises would push in the opposite direction. Ms Romer said the latest economic data were encouraging, following a weaker patch a month ago. "I am more optimistic that we are getting close to the bottom, " she said. The CEA chairman, who has forecast a sharper rebound in 2010 than most economists, said she had lowered her estimates for growth this year "and also for next year, a bit" since the start of the year. She said the consensus forecast that unemployment would continue to rise for the rest of this year and peak early next year was probably accurate. But she added: "I still hold out hope it will be a V-shaped recovery. It might not be the most likely scenario but it is not as unlikely as many people think. 'We are going to get some serious comph from the stimulus, there is the inventory cycle and I believe there is some pent-up demand by consumers." Even so, Ms Romer warned against tightening monetary and fiscal stimulus prematurely. She said the authorities should continue to work on their exit plans but not implement them until the economy came back strongly. 'It is important to think about it now but policymakers should not start acting until we are really recovering well and are approaching full employment." Ms Romer, an expert on monetary policy, said she thought the risk of inflation was "very low". 'With unemployment and unused capacity high, it is not as if inflation is going to creep up on us. We will have a long period of time to figure out what to do." Wasted' chances, Page 4 Fed must reassure, Page 9 Copyright The Financial Times Limited 2010. Print a single copy of this article for personal use. Contact us if you wish to print more to distribute to others